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Bulletin No.

2005-7
February 14, 2005

HIGHLIGHTS
OF THIS ISSUE
These synopses are intended only as aids to the reader in
identifying the subject matter covered. They may not be
relied upon as authoritative interpretations.

INCOME TAX menting the principles of Rev. Rul. 2004–43. Rev. Rul.
2004–43 revoked.

REG–117969–00, page 533. Notice 2005–11, page 493.


Proposed regulations amend previously proposed regulations This notice provides interim guidance relating to section 6707A
that provided a functional definition of “statutory merger or of the Code, Penalty for failure to include reportable transac-
consolidation” under section 368(a)(1)(A) of the Code. These tion information with return, as added by the American Jobs
proposed regulations delete the requirement that transactions Creation Act of 2004. This notice states that a taxpayer may
must be carried out under domestic law in order to qualify as incur a penalty under section 6707A with respect to each fail-
statutory mergers or consolidations. A public hearing is sched- ure to disclose a reportable transaction within the time, and in
uled for May 19, 2005. the form and manner, provided by section 6011 and its regu-
lations.
REG–125628–01, page 536.
Proposed regulations amending the income tax regulations Notice 2005–12, page 494.
under various provisions of the Code to account for statu- This notice provides interim guidance relating to section
tory mergers and consolidations under section 368(a)(1)(A) 6662A of the Code, Imposition of accuracy-related penalty
(including reorganizations described in section 368(a)(2)(D) on understatements with respect to reportable transactions,
and (E)) involving one or more foreign corporations. The section 6662, Imposition of accuracy-related penalty on un-
regulations are issued concurrently with proposed regulations derpayments, and section 6664, Definitions and special rules.
(REG–117969–00) that would amend the definition of a reorga-
nization under section 368(a)(1)(A) to include certain statutory Notice 2005–14, page 498.
mergers or consolidations effected pursuant to foreign law. A Income attributable to domestic production activities.
public hearing is scheduled for May 19, 2005. This notice provides interim guidance to taxpayers regarding
the deduction for income attributable to domestic production
Announcement 2005–12, page 555. activities under section 199 of the Code. Section 199 was en-
For purposes of the Archer MSA pilot program, under section acted as part of the American Jobs Creation Act of 2004, and
220(j)(2) of the Code, 2004 is not a cut-off year. allows a deduction equal to 3 percent (for 2005 and 2006)
of the lesser of the qualified production activities income of
the taxpayer for the taxable year, or the taxable income of the
ADMINISTRATIVE taxpayer for the taxable year, subject to certain limits. The ap-
plicable percentage rises to 6 percent for 2007, 2008, and
2009, and 9 percent for 2010 and subsequent years.
Rev. Rul. 2005–10, page 492.
Partnership mergers. This ruling informs taxpayers that the
Treasury Department and the Service intend to issue regula-
tions under sections 704(c)(1)(B) and 737 of the Code imple-

(Continued on the next page)

Finding Lists begin on page ii.


Notice 2005–15, page 527.
This notice provides that the Treasury Department and the Ser-
vice intend to issue regulations involving partnerships under
sections 704(c)(1)(B) and 737 of the Code implementing the
principles of Rev. Rul. 2004–43, and that the regulations will
be effective for distributions occurring after the date on which
the notice is released to the public.

Rev. Proc. 2005–14, page 528.


Like-kind exchange of a principal residence. This proce-
dure provides guidance on applying the exclusion of gain from
the sale or exchange of a principal residence under section 121
of the Code and the nonrecognition of gain from the exchange
of like-kind property under section 1031 to a single exchange
of property.

February 14, 2005 2005–7 I.R.B.


The IRS Mission
Provide America’s taxpayers top quality service by helping applying the tax law with integrity and fairness to all.
them understand and meet their tax responsibilities and by

Introduction
The Internal Revenue Bulletin is the authoritative instrument of court decisions, rulings, and procedures must be considered,
the Commissioner of Internal Revenue for announcing official and Service personnel and others concerned are cautioned
rulings and procedures of the Internal Revenue Service and for against reaching the same conclusions in other cases unless
publishing Treasury Decisions, Executive Orders, Tax Conven- the facts and circumstances are substantially the same.
tions, legislation, court decisions, and other items of general
interest. It is published weekly and may be obtained from the
The Bulletin is divided into four parts as follows:
Superintendent of Documents on a subscription basis. Bulletin
contents are compiled semiannually into Cumulative Bulletins,
which are sold on a single-copy basis. Part I.—1986 Code.
This part includes rulings and decisions based on provisions of
It is the policy of the Service to publish in the Bulletin all sub- the Internal Revenue Code of 1986.
stantive rulings necessary to promote a uniform application of
the tax laws, including all rulings that supersede, revoke, mod- Part II.—Treaties and Tax Legislation.
ify, or amend any of those previously published in the Bulletin. This part is divided into two subparts as follows: Subpart A,
All published rulings apply retroactively unless otherwise indi- Tax Conventions and Other Related Items, and Subpart B, Leg-
cated. Procedures relating solely to matters of internal man- islation and Related Committee Reports.
agement are not published; however, statements of internal
practices and procedures that affect the rights and duties of
taxpayers are published. Part III.—Administrative, Procedural, and Miscellaneous.
To the extent practicable, pertinent cross references to these
subjects are contained in the other Parts and Subparts. Also
Revenue rulings represent the conclusions of the Service on the included in this part are Bank Secrecy Act Administrative Rul-
application of the law to the pivotal facts stated in the revenue ings. Bank Secrecy Act Administrative Rulings are issued by
ruling. In those based on positions taken in rulings to taxpayers the Department of the Treasury’s Office of the Assistant Sec-
or technical advice to Service field offices, identifying details retary (Enforcement).
and information of a confidential nature are deleted to prevent
unwarranted invasions of privacy and to comply with statutory
requirements. Part IV.—Items of General Interest.
This part includes notices of proposed rulemakings, disbar-
ment and suspension lists, and announcements.
Rulings and procedures reported in the Bulletin do not have the
force and effect of Treasury Department Regulations, but they
may be used as precedents. Unpublished rulings will not be The last Bulletin for each month includes a cumulative index
relied on, used, or cited as precedents by Service personnel in for the matters published during the preceding months. These
the disposition of other cases. In applying published rulings and monthly indexes are cumulated on a semiannual basis, and are
procedures, the effect of subsequent legislation, regulations, published in the last Bulletin of each semiannual period.

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.

For sale by the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402.

2005–7 I.R.B. February 14, 2005


Part I. Rulings and Decisions Under the Internal Revenue Code
of 1986
Section 121.—Exclusion to § 704(c) gain or loss that is created in an ulations will be effective for distributions
of Gain From Sale of assets-over partnership merger. Rev. Rul. occurring after January 19, 2005. See
Principal Residence 2004–43 holds that § 704(c)(1)(B) applies Notice 2005–15, published in this issue of
to newly created § 704(c) gain or loss in the Internal Revenue Bulletin.
26 CFR 1.121–1: Exclusion of gain from sale or ex-
property contributed by the transferor part-
change of a principal residence. EFFECT ON OTHER REVENUE
nership to the continuing partnership in an
Guidance is provided on applying the exclusion of assets-over partnership merger, but does RULING(S)
gain from the sale or exchange of a principal resi- not apply to newly created reverse § 704(c)
dence under § 121 of the Code and the nonrecognition
Rev. Rul. 2004–43 is revoked.
gain or loss resulting from a revaluation
of gain from the exchange of like-kind property under of property in the continuing partnership.
§ 1031 of the Code to a single exchange of property.
DRAFTING INFORMATION
The revenue ruling also holds that for pur-
See Rev. Proc. 2005-14, page 528.
poses of § 737(b), net precontribution gain The principal author of this revenue rul-
includes newly created § 704(c) gain or ing is Laura Fields of the Office of As-
Section 704.—Partner’s loss in property contributed by the trans- sociate Chief Counsel (Passthroughs and
Distributive Share feror partnership to the continuing partner- Special Industries). For further informa-
ship in an assets-over partnership merger, tion regarding this revenue ruling, con-
but does not include newly created reverse tact Ms. Fields at (202) 622–3050 (not a
Partnership mergers. This ruling in- § 704(c) gain or loss resulting from a reval- toll-free call).
forms taxpayers that the Treasury Depart- uation of property in the continuing part-
ment and the Service intend to issue reg- nership.
ulations under sections 704(c)(1)(B) and Some commentators have argued Section 1031.—Exchange
737 of the Code implementing the princi- that Rev. Rul. 2004–43 is not consis- of Property Held for
ples of Rev. Rul. 2004–43. Rev. Rul. tent with the current regulations under Productive Use or
2004–43 revoked. §§ 704(c)(1)(B) and 737, and that the con- Investment
clusions in the ruling should not be applied
Guidance is provided on applying the exclusion of
Rev. Rul. 2005–10 retroactively. In response to these com-
gain from the sale or exchange of a principal resi-
ments, the Treasury Department and the dence under § 121 of the Code and the nonrecognition
Rev. Rul. 2004–43, 2004–18 I.R.B. Service intend to issue regulations under of gain from the exchange of like-kind property under
842, issued on April 12, 2004, addresses §§ 704(c)(1)(B) and 737 implementing the § 1031 of the Code to a single exchange of property.
the application of §§ 704(c)(1)(B) and 737 principles of Rev. Rul. 2004–43. The reg- See Rev. Proc. 2005-14, page 528.

2005–7 I.R.B. 492 February 14, 2005


Part III. Administrative, Procedural, and Miscellaneous
New Penalty Section 6707A rations With Total Assets of $10 Million or 6707A provides that “the IRS Commis-
and Rescission Authority More, as provided by Rev. Proc. 2004–45, sioner or his delegate can rescind (or
2004–31 I.R.B. 140 (August 2, 2004). abate) the penalty.” H.R. Conf. Rep. No.
Notice 2005–11 Section 6011 also requires the disclo- 755, 108th Cong., 2d Sess. at 373 (2004).
sure of listed transactions under section Section 6707A(e) also provides that
The purpose of this notice is to alert 20.6011–4 of the Estate Tax Regulations, a person that is required to file periodic
taxpayers to new section 6707A of the section 25.6011–4 of the Gift Tax Regu- reports under section 13 or 15(d) of the Se-
Internal Revenue Code. This notice an- lations, section 31.6011–4 of the Employ- curities Exchange Act of 1934, or required
nounces that the Internal Revenue Service ment Tax Regulations, section 53.6011–4 to be consolidated with another person
and the Treasury Department will issue of the Foundation and Similar Excise Tax for purposes of those reports, must dis-
regulations under section 6707A, which Regulations, section 54.6011–4 of the close the requirement to pay the following
will apply to returns and statements the Pension Excise Tax Regulations, and sec- penalties in the reports to the Securities
due date for which is after October 22, tion 56.6011–4 of the Public Charity Tax and Exchange Commission for the peri-
2004, and provides guidance regarding the on Excess Lobbying Expenditure Regula- ods specified by the Secretary: (1) the
imposition and rescission of penalties un- tions. penalty under section 6707A for failure
der section 6707A. This notice also invites Prior to the enactment of section to disclose a listed transaction; (2) the 30
comments from the public regarding rules 6707A, there was no monetary penalty percent penalty under section 6662A for
and standards relating to section 6707A. for the failure by a taxpayer to disclose a an understatement attributable to an undis-
reportable transaction. closed listed transaction or undisclosed
BACKGROUND AND PRIOR LAW reportable avoidance transaction; and (3)
THE AMERICAN JOBS CREATION the 40 percent penalty under section 6662
Section 6011 and the regulations there- ACT OF 2004 for a gross valuation misstatement if the
under require a taxpayer that has partic-
30 percent penalty under section 6662A
ipated in a reportable transaction to dis- The American Jobs Creation Act of
would have applied, but for the applica-
close certain information with respect to 2004, P.L. 108–357, 118 Stat. 1418 (the
tion of section 6662A(e)(2)(c)(ii). Section
the reportable transaction with its tax re- Act) was enacted on October 22, 2004.
6707A(e) also provides that the failure to
turn. Section 1.6011–4(b) of the Income Section 811 of the Act added section
make a disclosure on reports filed with the
Tax Regulations describes six categories 6707A to the Code to provide a monetary
Securities and Exchange Commission as
of reportable transactions. One category penalty for the failure to include on any
required by the Secretary shall be treated
of reportable transactions is a transaction return or statement any information re-
as a failure to include information with
that is the same as, or substantially similar quired to be disclosed under section 6011
respect to a listed transaction for which
to, one of the types of transactions that the with respect to a reportable transaction.
the penalty under section 6707A applies.
Internal Revenue Service has determined Section 6707A(b)(1) provides that the
The penalty under section 6707A is in
to be a tax avoidance transaction and iden- penalty for failure to include information
addition to any other potentially applica-
tified by notice, regulation, or other form with respect to a reportable transaction,
ble penalties, including accuracy-related
of published guidance as a “listed transac- other than a listed transaction, is $10,000
penalties under sections 6662 and 6662A.
tion.” Section 1.6011–4(b)(2). in the case of a natural person, and $50,000
The penalty under section 6707A will be
Section 1.6011–4(d) requires that a in any other case. Section 6707A(b)(2)
imposed regardless of whether the transac-
taxpayer file a disclosure statement on provides that the penalty for failure to in-
tion results in an underpayment of tax.
Form 8886, Reportable Transaction Dis- clude information with respect to a listed
Section 6707A is effective for returns
closure Statement, for each reportable transaction is $100,000 in the case of a
and statements the due date for which is
transaction in which the taxpayer partic- natural person, and $200,000 in any other
after October 22, 2004.
ipated. Section 1.6011–4(e)(1) provides case.
that a reportable transaction disclosure Section 6707A(d)(1) grants the Com- INTERIM GUIDANCE
statement is due when the taxpayer files missioner authority to rescind all or a
an original or amended return that reflects portion of any penalty imposed by sec- The Internal Revenue Service and the
the taxpayer’s participation in a reportable tion 6707A if (1) the violation relates Treasury Department intend to issue reg-
transaction. The taxpayer also must send a to a reportable transaction that is not a ulations providing rules under section
copy of the disclosure statement to the IRS listed transaction and (2) rescission of the 6707A. Because section 6707A is effec-
Office of Tax Shelter Analysis (OTSA) at penalty would promote compliance with tive for returns and statements the due
the same time that the taxpayer first files the requirements of the Code and effective date for which is after October 22, 2004,
a disclosure statement with a return. In tax administration. Section 6707A(d)(2) however, the Service and Treasury are
certain circumstances, a taxpayer may be provides that the Commissioner’s deter- providing the following interim guidance
deemed to have satisfied its disclosure mination whether to rescind the penalty regarding the imposition and rescission
obligations by filing Schedule M–3, Net may not be reviewed in any judicial pro- of penalties under section 6707A. These
Income (Loss) Reconciliation for Corpo- ceeding. The legislative history to section

February 14, 2005 493 2005–7 I.R.B.


interim rules will apply until further guid- to OTSA, if applicable, even if the return tion, Washington, DC 20044. Submis-
ance is issued. is filed after the due date. In addition, sions also may be hand delivered Mon-
a penalty under section 6707A will not day through Friday between the hours of
A. Imposition of the Section 6707A be imposed if the disclosure statement is 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (No-
Penalty attached to a return that is filed after the tice 2005–11), Courier’s Desk, Internal
due date for filing the return unless the Revenue Service, 1111 Constitution Av-
The Service will impose a penalty un-
taxpayer fails to provide a copy of the dis- enue, NW, Washington, DC. Alternatively,
der section 6707A with respect to each
closure statement to OTSA, if applicable. taxpayers may submit electronic com-
failure to disclose a reportable transaction
ments directly to the IRS e-mail address:
within the time and in the form and manner B. Rescission Authority notice.comments@irscounsel.treas.gov.
provided by section 6011 and the regula-
tions thereunder. Accordingly, a taxpayer If it has been determined that a tax- DRAFTING INFORMATION
will be subject to a penalty under section payer failed to disclose a reportable trans-
6707A for: (1) the failure to attach a re- action and a penalty is imposed under sec- The principal author of this notice
portable transaction disclosure statement tion 6707A, section 6707A(d) authorizes is Matthew S. Cooper of the Office of As-
to an original or amended return; or (2) the the Commissioner to rescind all or any sociate Chief Counsel (Procedure and Ad-
failure to provide a copy of a disclosure portion of a penalty imposed under sec- ministration), Administrative Provisions
statement to OTSA, if required. A tax- tion 6707A only if (1) the violation re- and Judicial Practice Division. For further
payer that fails to attach a reportable trans- lates to a reportable transaction other than information regarding this notice, con-
action disclosure statement to an original a listed transaction and (2) rescission of the tact Matthew S. Cooper at 202–622–4940
or amended return and fails to provide a penalty would promote compliance with (not a toll-free call).
copy of a required disclosure statement to the requirements of the Code and effec-
OTSA will be subject to a single penalty tive tax administration. In determining
under section 6707A. The following exam- whether rescission would promote compli-
ples illustrate this provision: ance with the requirements of the Code and Temporary Rules Under
Example 1: Taxpayer T was required to attach a
effective tax administration, the Commis-
Form 8886 to its original return for the 2005 taxable Section 6662A and Sections
sioner (or his delegate) will take into ac-
year and to send a copy of the Form 8886 to OTSA at
count all of the relevant facts and circum- 6662 and 6664, as Amended
the time it filed its original return. T failed to attach
the Form 8886 to its return and failed to send a copy stances, including: (1) whether the tax-
of the Form 8886 to OTSA. Taxpayer T is subject to a payer has a history of complying with the Notice 2005–12
penalty under section 6707A for a failure to disclose
tax laws; (2) whether the violation results
because Taxpayer T failed to comply with both of The purpose of this notice is to alert tax-
the disclosure requirements. A penalty under section
from an unintentional mistake of fact; and
(3) whether imposing the penalty would be payers to the recent enactment of section
6707A also would apply if T had failed to comply
with either of the two requirements. against equity and good conscience. The 6662A and amendments to sections 6662
Example 2: Same as Example 1, except that T Commissioner’s determination whether to and 6664 of the Internal Revenue Code,
subsequently filed an amended return for 2005 that
rescind a penalty in whole or in part is not provide interim guidance relating to these
reflects Taxpayer T’s participation in the reportable provisions and invite comments from the
transaction. Taxpayer T failed to attach a Form
reviewable by the IRS Appeals Division or
any court. public regarding the rules and standards re-
8886 to the amended return as required by section
1.6011–4(e)(1). Accordingly, Taxpayer T is subject lating to section 6662A and sections 6662
to an additional penalty under section 6707A for REQUEST FOR COMMENTS and 6664, as amended.
failing to disclose a reportable transaction.
The penalty under section 6707A ap- The Service and Treasury invite inter- BACKGROUND
plies to each failure to provide a disclosure ested persons to submit comments regard-
statement that is required to be attached to ing rules and standards relating to section The American Jobs Creation Act of
an original or amended return filed after 6707A, including the factors that should 2004, Pub. L. No. 108–357, 118 Stat.
October 22, 2004 (with a copy sent to be considered in exercising the rescis- 1418 (the Act), was enacted on October 22,
OTSA, if required), regardless of whether sion authority under section 6707A(d). 2004. Section 812 of the Act added section
the original return was due on or be- Comments are also requested on how 6662A, which provides a new penalty for
fore October 22, 2004. Under section voluntary, but untimely disclosures (e.g., understatements with respect to reportable
1.6011–4(e)(1), a reportable transaction if a taxpayer failed to make a required transactions. Section 812 also added sec-
disclosure statement is due upon the filing disclosure upon filing a return, but sub- tion 6664(d), which provides a defense
of a return or amended return reflecting sequently submits the required disclosure to the penalty under section 6662A if the
a taxpayer’s participation in a reportable statement) should be treated in applying taxpayer acted with reasonable cause and
transaction. Accordingly, a penalty under the section 6707A penalty. Comments are in good faith. Sections 812 and 819 of the
section 6707A will not be imposed until encouraged to be submitted by February Act amended section 6662(d) to modify
a taxpayer fails to provide the required 28, 2005, to: Internal Revenue Service, the accuracy-related penalty under section
disclosure statement with an original or CC:PA:LPD:PR (Notice 2005–11), room 6662(d) for substantial understatements of
amended return, or fails to provide a copy 5203, P.O. Box 7604, Ben Franklin Sta- income tax.

2005–7 I.R.B. 494 February 14, 2005


(1) Section 6662A, Imposition of (2) Section 6662, Imposition of other than corporations, will not be re-
Accuracy-Related Penalty on Accuracy-Related Penalty on duced even if the taxpayer has substantial
Understatements with Respect to Underpayments. authority and a reasonable belief that the
Reportable Transactions. tax treatment of an item attributable to a
Section 6662(d) imposes a 20-percent tax shelter item was more likely than not
Section 812 of the Act added section accuracy-related penalty for any substan- the proper treatment. The taxpayer may,
6662A to the Code, which provides that a tial understatement of income tax. Under however, demonstrate reasonable cause
20-percent accuracy-related penalty may section 6662(d)(1)(B), as amended, in the and good faith under section 6664(c).
be imposed on any reportable transaction case of a corporation (other than an S cor-
understatement. Under section 6662A, a poration or a personal holding company), (3) Section 6664, Definitions and Special
“reportable transaction understatement” there is a substantial understatement of in- Rules.
means the sum of (1) the product of (A) the come tax for any taxable year if the amount
amount of the increase (if any) in taxable of the understatement for the taxable year The accuracy-related penalty under
income which results from a difference exceeds the lesser of (1) 10 percent of the section 6662A does not apply with respect
between the proper tax treatment of an tax required to be shown on the return for to any portion of a reportable transac-
item to which section 6662A applies and the taxable year (or, if greater, $10,000), tion understatement if, pursuant to section
the taxpayer’s treatment of such item (as or (2) $10,000,000. In the case of all other 6664(d), it is shown that there was rea-
shown on the taxpayer’s return of tax), taxpayers, an understatement is substantial sonable cause and the taxpayer acted in
and (B) the highest rate of tax imposed if it exceeds the greater of 10 percent of the good faith with respect to that portion of
by section 1 (section 11 in the case of a tax required to be shown on the return or the understatement. A taxpayer does not
corporation), and (2) the amount of the $5,000. have reasonable cause and did not act in
decrease (if any) in the aggregate amount Under section 6662(d)(2), an under- good faith unless (1) the relevant facts
of credits determined under subtitle A statement is the excess of (i) the amount affecting the tax treatment of the item are
which results from a difference between of tax required to be shown on the return adequately disclosed in accordance with
the taxpayer’s treatment of an item to for the taxable year over (ii) the amount of regulations prescribed under section 6011;
which section 6662A applies (as shown tax imposed which is shown on the return, (2) there is or was substantial authority;
on the taxpayer’s return of tax) and the reduced by any rebate. This excess is de- and (3) the taxpayer reasonably believed
proper tax treatment of such item. termined without regard to items to which that its treatment of the item was more
The penalty provided by section 6662A section 6662A applies. The reportable likely than not the proper tax treatment. A
applies only (1) to listed transactions and transaction understatement, however, is taxpayer is treated as having a reasonable
(2) to reportable transactions (other than added to the understatement calculated belief only if the belief is based on the
a listed transaction) if a significant pur- under section 6662(d)(2) for purposes of facts and the law that exist at the time the
pose of the transaction is the avoidance or determining whether an understatement return is filed and the belief relates solely
evasion of Federal income tax. In addi- is substantial under section 6662(d)(1). to the taxpayer’s chances of success on the
tion, a higher 30-percent penalty applies Under section 6662A(e)(1)(B), in the case merits of the tax treatment of the issue.
to a reportable transaction understatement of an understatement, the addition to tax An opinion of a tax advisor may not
if a taxpayer does not adequately disclose, under section 6662(a) applies only to the be relied upon to establish the reasonable
in accordance with regulations prescribed excess of the amount of the substantial belief of the taxpayer if the advisor or
under section 6011, the relevant facts af- understatement over the aggregate amount the opinion is disqualified. A tax advi-
fecting the tax treatment of the item giv- of the reportable transaction understate- sor is disqualified if the tax advisor (1) is
ing rise to the reportable transaction un- ments. Accordingly, the accuracy-related a material advisor under section 6111, as
derstatement. The reasonable cause and penalty attributable to substantial under- amended, and participates in the organiza-
good faith defense is not available with re- statement of income tax does not apply to tion, management, promotion, or sale of
spect to the 30-percent penalty. See I.R.C. an understatement on which the section the transaction or is related to any person
§§ 6662A(c) and 6664(d)(2)(A). 6662A penalty is imposed. who so participates; (2) is compensated di-
Section 6662A(e)(3) sets forth a special Section 6662A does not apply to any rectly or indirectly by a material advisor
rule for amended returns. The tax treat- portion of an understatement on which the with respect to the transaction; (3) has a
ment on an amendment or supplement to section 6663 fraud penalty or the section fee arrangement with respect to the trans-
a return is not taken into account in deter- 6662(h) accuracy-related penalty for a action that is contingent on all or part of the
mining the amount of a reportable trans- gross valuation misstatement is imposed. intended tax benefits from the transaction
action understatement if the amendment or Section 6662(e) (substantial valuation being sustained; or (4) has any other dis-
supplement is filed after the earlier of (1) misstatement) does not apply to any por- qualifying financial interest with respect to
the date the taxpayer is first contacted by tion of an understatement on which a the transaction as identified by the Secre-
the IRS regarding an examination of the re- penalty under section 6662A is imposed. tary.
turn or (2) any other date specified by the Under section 6662(d)(2), as amended, An opinion is disqualified if the opin-
Secretary. the understatement with respect to any ion (1) is based on unreasonable factual
item attributable to a tax shelter item, or legal assumptions (including assump-
including tax shelter items of taxpayers tions as to future events); (2) unreason-

February 14, 2005 495 2005–7 I.R.B.


ably relies on representations, statements, dates after which a taxpayer may not file a opinion, prospectus, or other document de-
findings or agreements of the taxpayer or “qualified amended return.” scribing the transaction, or (C) register the
any other person; (3) does not identify and transaction with any federal, state or local
consider all relevant facts; or (4) fails to (3) Disqualified tax advisor government body.
meet any other requirement as the Secre- A material advisor participates in the
As stated above, a taxpayer may not
tary may prescribe. “management” of a transaction if the ma-
rely on the opinion of a disqualified tax ad-
terial advisor is involved in the decision-
visor to establish reasonable belief under
INTERIM PROVISIONS making process regarding any business ac-
section 6664(d). A disqualified tax advisor
tivity with respect to the transaction. Par-
is any advisor who (a) is a material advisor
The Treasury Department and the IRS ticipation in the management of a trans-
(under section 6111, as amended) and who
intend to issue regulations implementing action includes managing assets, directing
participates in the organization, manage-
the requirements of section 6662A and business activity, or acting as general part-
ment, promotion or sale of the transaction
sections 6662 and 6664, as amended. Sec- ner, trustee, director or officer of an entity
or is related (within the meaning of section
tion 812 of the Act, which added section involved in the transaction.
267(b) or 707(b)(1)) to any person who so
6662A and amended sections 6662 and A material advisor participates in the
participates, (b) has a disqualified compen-
6664 is effective for taxable years ending “promotion or sale” of a transaction if the
sation arrangement, or (c) has a disqualify-
after October 22, 2004. Section 819 of material advisor is involved in the market-
ing financial interest identified by the Sec-
the Act, which separately amended sec- ing of the transaction or tax strategy. Mar-
retary.
tion 6662, is effective for taxable years keting activities include: (1) soliciting, di-
A material advisor is defined in
beginning after October 22, 2004. The rectly or through an agent, taxpayers to en-
Treas. Reg. § 301.6112–1. In addi-
Treasury Department and the IRS provide ter into a transaction or tax strategy us-
tion, the existing rules under Treas. Reg.
the following interim rules to implement ing direct contact, mail, telephone or other
§ 301.6112–1(c)(2), (c)(3) and (d) (with-
the requirements of sections 6662, 6662A means; (2) placing an advertisement for
out regard to the provisions relating to a
and 6664. These interim rules will apply the transaction in a newspaper, magazine,
transaction required to be registered under
until further guidance is issued. or other publication or medium; or (3) in-
former section 6111), including the min-
structing or advising others with respect to
imum fee amounts for listed transactions
(1) Adequate disclosure in accordance marketing of the transaction or tax strat-
under Treas. Reg. § 301.6112–1(c)(3)(ii),
with section 6011 egy.
shall apply. See Notice 2004–80, 2004–50
Consistent with the legislative history,
I.R.B. 963 (December 13, 2004). The def-
As noted above, the 30-percent penalty a tax advisor, including a material advi-
inition of material advisor, and the rules
provided by section 6662A applies to a sor, will not be treated as participating
described here, will apply for purposes of
reportable transaction understatement if in the organization, management, promo-
section 6662A until the IRS issues further
the taxpayer does not adequately disclose tion or sale of a transaction if the tax ad-
guidance.
the relevant facts affecting the tax treat- visor’s only involvement is rendering an
ment of the item under section 6011. A (a) Organization, Management, opinion regarding the tax consequences of
taxpayer has adequately disclosed the Promotion or Sale the transaction. In the course of prepar-
facts for purposes of section 6662A, and ing a tax opinion, a tax advisor is permit-
section 6664(d)(2)(A), if the taxpayer has A material advisor participates in the ted to suggest modifications to the trans-
filed a disclosure statement in the form “organization” of a transaction if the advi- action, but the tax advisor may not sug-
and manner prescribed by Treas. Reg. sor: gest material modifications to the trans-
§ 1.6011–4(d) or the taxpayer has been (1) devises, creates, investigates or ini- action that assist the taxpayer in obtain-
deemed to have satisfied its disclosure tiates the transaction or tax strategy; ing the anticipated tax benefits. Merely
obligations under Rev. Proc. 2004–45, (2) devises the business or financial performing support services or ministerial
2004–31 I.R.B. 140 (August 2, 2004), as plans for the transaction or tax strategy; functions such as typing, photocopying, or
applicable, or any other published guid- (3) carries out those plans through ne- printing will not be considered participa-
ance prescribing the form and manner of gotiations or transactions with others; or tion in the organization, management, pro-
disclosure under section 6011. (4) performs acts relating to the devel- motion or sale of a transaction.
opment or establishment of the transaction.
(2) Special rule for amended returns (b) Disqualified Compensation
The performance of an act relating to the Arrangements
For purposes of determining the amount development or establishment of a trans-
of any reportable transaction understate- action includes preparing documents that As stated above, a disqualified tax ad-
ment, the IRS will not take into account an (A) establish the structure used in connec- visor includes a tax advisor who has a
amendment or supplement to a return filed tion with the transaction, e.g., a partner- disqualified compensation arrangement.
after the dates specified in Treas. Reg. ship agreement or articles of incorpora- A disqualified compensation arrangement
§ 1.6664–2(c)(3) and Notice 2004–38, tion, (B) describe the transaction for use includes (1) an arrangement by which the
2004–21 I.R.B. 949 (May 24, 2004), or in the promotion or sale of the transac- advisor is compensated directly or indi-
any amendments thereto, which are the tion, e.g., an offering memorandum, tax rectly by a material advisor with respect

2005–7 I.R.B. 496 February 14, 2005


to the transaction or (2) a fee arrangement § 1.6011–4(b)(4)(iii) do not give rise to a provided in Rev. Proc. 94–69, 1994–2
with respect to the transaction that is con- disqualified compensation arrangement. C.B. 804, should apply.
tingent on all or part of the intended tax
benefits from the transaction being sus- REQUEST FOR COMMENTS Section 6664. Definitions and Special
tained. See I.R.C. § 6664(d)(3)(B)(ii). Rules.
The Treasury Department and the IRS
Until further guidance is issued, a tax
intend to issue regulations implementing 1. Definition of “disqualified tax advi-
advisor also will be treated as a disquali-
section 6662A and the amendments to sec- sor,” including definition of “participates
fied tax advisor, even if not a material advi-
tions 6662 and 6664 and invite interested in the management, organization, promo-
sor, if the tax advisor has a referral fee or a
persons to submit comments regarding tion or sale of a transaction”;
fee-sharing arrangement by which the ad-
rules and standards under sections 6662, 2. Providing suggested modifications
visor is compensated directly or indirectly
6662A and 6664 in general and on the regarding the transaction;
by a material advisor. In addition, an ar-
specific matters set forth below, including 3. Definition of “disqualifying finan-
rangement will be treated as a disqualified
particularly item 2 under “Definition and cial interest”;
compensation arrangement if there is an
Special Rules” regarding the extent to 4. Additional requirements relating to
agreement or understanding (oral or writ-
which a tax advisor should be permitted “disqualified opinions.”
ten) with a material advisor of a reportable
to suggest modifications to a transaction Comments are encouraged to be sub-
transaction pursuant to which the tax advi-
without becoming a “disqualified tax ad- mitted by February 28, 2005, to: Internal
sor is expected to render a favorable opin-
visor.” Revenue Service, CC:PA:LPD:PR (Notice
ion regarding the tax treatment of the trans-
2005–12), room 5203, P.O. Box 7604, Ben
action to any person referred by the ma- Section 6662A. Imposition of Franklin Station, Washington, DC 20224.
terial advisor. A tax advisor will not be Accuracy-Related Penalty on Submissions may be hand delivered Mon-
treated as having a disqualified compen- Understatements with Respect to day through Friday between the hours of
sation arrangement if a material advisor Reportable Transactions. 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (No-
merely recommends the tax advisor who
tice 2005–12), Courier’s Desk, Internal
does not have an agreement or understand- 1. Definition of “reportable transaction
Revenue Service, 1111 Constitution Av-
ing with the material advisor to render a understatement”;
enue, NW, Washington, DC. Alternatively,
favorable opinion regarding the tax treat- 2. Coordination of the reportable trans-
taxpayers may submit electronic com-
ment of a transaction. action understatement penalty with the
ments directly to the IRS e-mail address:
In addition, a disqualified compensa- substantial understatement penalty, in-
notice.comments@irscounsel.treas.gov.
tion arrangement includes a fee that is cluding the methodology for calculating
contingent on all or part of the intended the excess of the aggregate reportable DRAFTING INFORMATION
tax benefits from the transaction being transaction understatement;
sustained, including agreements that pro- 3. Coordination of the reportable trans- The principal author of this notice
vide that (1) a taxpayer has the right to a action understatement penalty with the ac- is Heather L. Dostaler of the Office of
full or partial refund of fees if all or part of curacy-related penalty on underpayments, Associate Chief Counsel (Procedure &
the tax consequences from the transaction including the penalty on underpayments Administration), Administrative Provi-
are not sustained or (2) the amount of the attributable to negligence or disregard of sions and Judicial Practice Division. For
fee is contingent on the taxpayer’s realiza- rules or regulations, and the fraud penalty; further information regarding this no-
tion of tax benefits from the transaction. and tice, contact Heather L. Dostaler at (202)
Transactions described in Treas. Reg. 4. Special rules for amended returns, 622–4940 (not a toll-free call).
including whether rules similar to the rules

February 14, 2005 497 2005–7 I.R.B.


Section 199.—Income
Attributable to Domestic
Production Activities
Notice 2005–14

CONTENTS

SECTION 1. PURPOSE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 502

SECTION 2. OVERVIEW OF § 199 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 502


.01 In General. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 502
.02 Qualified Production Activities Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 502
.03 Pass-thru Entities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503
.04 Individuals.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503
.05 Patrons of Certain Cooperatives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503
.06 Expanded Affiliated Groups. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503
.07 Trade or Business Requirement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503
.08 Alternative Minimum Tax. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503
.09 Authority to Prescribe Regulations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503

SECTION 3. EXPLANATION OF INTERIM GUIDANCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504


.01 In General. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504
.02 Wage Limitation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504
(1) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504
(2) Wages paid by other entities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504
(3) Acquisitions and dispositions of a trade or business (or major portion). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504
(4) Non-duplication rule. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504
(5) Definition of W–2 wages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504
(b) Methods for calculating W–2 wages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504
.03 Determining Qualified Production Activities Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504
.04 Determining Domestic Production Gross Receipts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505
(1) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505
(2) Definition of “gross receipts.”. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505
(3) Definition of “manufactured, produced, grown, or extracted.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505
(b) Consistency with § 263A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505
(4) Definition of “by the taxpayer.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505
(5) Definition of “in whole or in significant part.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 506
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 506
(b) Substantial in nature. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 506
(c) Safe harbor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507
(d) Certain activities and costs disregarded.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507
(6) Definition of “United States.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507
(7) Definition of “derived from the lease, rental, license, sale, exchange, or other disposition of qualifying
production property.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507
(b) Allocation of gross receipts – embedded services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508
(c) Advertising income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508
(d) Computer software. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508
(8) Definition of “qualifying production property.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508
(b) Tangible personal property. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508

2005–7 I.R.B. 498 February 14, 2005


(c) Computer software. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509
(i) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509
(ii) Tangible personal property not included. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509
(d) Sound recordings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509
(9) Definition of “qualified film.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509
(b) Production personnel. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509
(c) Compensation for services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510
(d) Determination of 50 percent. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510
(10) Electricity, natural gas, and potable water. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510
(b) Natural gas. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510
(c) Potable water. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510
(11) Definition of “construction performed in the United States.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510
(a) Construction of real property. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510
(b) Activities constituting construction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510
(c) Definition of “infrastructure.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511
(d) Definition of “substantial renovation.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511
(e) “Derived from construction.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511
(i) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511
(ii) Taxpayers deriving gross receipts from construction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511
(12) Definition of “engineering and architectural services.”. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511
(b) Performance of services in the United States.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511
(c) Construction projects within the United States. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511
(13) Exception for sales of certain food and beverages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511
.05 Determining Costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511
(1) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511
(2) Allocation of cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 512
(3) Allocation and apportionment of deductions.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 512
(a) Three alternative methods. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 512
(b) Treatment of certain deductions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 512
.06 Application of § 199 to Pass-thru Entities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 512
(1) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 512
(2) Gain or loss from the disposition of an interest in a pass-thru entity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513
(3) Effective date of § 199 for pass-thru entities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513
.07 Patrons of Agricultural and Horticultural Cooperatives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513
.08 Expanded Affiliated Groups. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513
(1) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513
(2) Computation of expanded affiliated group’s § 199 deduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513
(b) Attribution of activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513
(c) Anti-avoidance rule. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513
(3) Allocation of expanded affiliated group’s § 199 deduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513
(4) Special rules for consolidated groups.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513
(5) Identification of members of the expanded affiliated group. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514
(6) Allocation of income and loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514
(a) Pro rata allocation method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514
(b) Closing of the books method.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514
(7) Total § 199 deduction for a corporation that is a member of an expanded affiliated group for some or all of
its taxable year.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514
(8) Computation of § 199 deduction for members of expanded affiliated group with different taxable years. . . . 514

SECTION 4. INTERIM GUIDANCE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514


.01 In General. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514
.02 Wage Limitation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514

February 14, 2005 499 2005–7 I.R.B.


(1) Rules of application. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514
(b) No application in determining whether amounts are wages for employment tax purposes.. . . . . . . . . . 514
(c) Application in case of taxpayer with short taxable year. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514
(d) Acquisitions and dispositions of a trade or business (or major portion). . . . . . . . . . . . . . . . . . . . . . . . . . 515
(e) Non-duplication rule. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
(2) Definition of “W–2 wages.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
(b) Methods for calculating W–2 wages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
(i) Unmodified box method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
(ii) Modified Box 1 method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
(iii) Tracking wages method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
.03 Determining Qualified Production Activities Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
(1) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
(2) Allocation of gross receipts.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
(3) Treatment of advance payments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516
.04 Determining Domestic Production Gross Receipts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516
(1) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516
(2) Definition of “gross receipts.”. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516
(3) Definition of “manufactured, produced, grown, or extracted.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516
(b) Consistency with § 263A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516
(4) Definition of “by the taxpayer.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517
(5) Definition of “in whole or in significant part.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517
(b) Substantial in nature. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517
(c) Safe harbor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517
(6) Definition of “United States.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517
(7) Definition of “derived from the lease, rental, license, sale, exchange, or other disposition of qualifying
production property.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517
(b) Allocation of gross receipts – embedded services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518
(c) Advertising income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518
(d) Computer software. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518
(e) Exception for certain oil and gas partnerships. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518
(8) Definition of “qualifying production property.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518
(b) Tangible personal property. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518
(c) Computer software. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518
(d) Sound recordings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
(9) Definition of “qualified film.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
(b) Compensation for services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
(c) Determination of 50 percent. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
(d) Exception. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
(10) Electricity, natural gas, and potable water. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
(b) Natural gas. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
(c) Potable water. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
(d) Exceptions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
(i) Electricity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520
(ii) Natural gas. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520
(iii) Potable water. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520
(11) Definition of “construction performed in the United States.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520
(a) Construction of real property. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520
(b) Activities constituting construction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520

2005–7 I.R.B. 500 February 14, 2005


(c) Definition of “infrastructure.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520
(d) Definition of “substantial renovation.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520
(e) “Derived from construction.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520
(12) Definition of “engineering and architectural services.”. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520
(b) Engineering services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520
(c) Architectural services.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520
(d) De minimis exception for performance of services in the United States.. . . . . . . . . . . . . . . . . . . . . . . . . . 521
(13) Exception for sales of certain food and beverages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521
(14) Related persons.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521
.05 Determining Costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521
(1) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521
(2) Costs of goods sold allocable to domestic production gross receipts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521
(b) Allocating cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521
(c) Special rules for imported items or services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521
(3) Other deductions allocable or apportionable to domestic production gross receipts. . . . . . . . . . . . . . . . . . . . . 521
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521
(b) Rules that apply to all allocation and apportionment methods. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522
(i) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522
(ii) Losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522
(iii) Net operating losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522
(iv) Deductions not attributable to the actual conduct of a trade or business. . . . . . . . . . . . . . . . . . . 522
(v) Deductions related to de minimis gross receipts and embedded services included in domestic
production gross receipts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522
(c) Section 861 method.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522
(i) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522
(ii) Deductions for charitable contributions.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522
(iii) Research and experimental expenditures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522
(d) Simplified deduction method.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522
(4) Small business simplified overall method.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522
(b) Qualifying small taxpayer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522
(5) Average annual gross receipts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523
.06 Application of § 199 to Pass-thru Entities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523
(1) Allocations to partners, shareholders, and similar interest holders. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523
(a) Partnerships. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523
(i) Determination at partner level. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523
(ii) Expenses.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523
(iii) W–2 wages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523
(b) S corporations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523
(i) Determination at S corporation shareholder level.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523
(ii) Expenses.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524
(iii) W–2 wages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524
(2) Gain or loss from the disposition of an interest in a pass-thru entity. . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524
(3) Effective date of § 199 for pass-thru entities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524
.07 Patrons of Agricultural and Horticultural Cooperatives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524
.08 Individuals.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524
.09 Expanded Affiliated Groups. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
(1) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
(2) Computation of expanded affiliated group’s § 199 deduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
(b) Attribution of activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
(c) Anti-avoidance rule. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
(3) Allocation of expanded affiliated group’s § 199 deduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
(4) Special rules for consolidated groups.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525

February 14, 2005 501 2005–7 I.R.B.


(5) Identification of members of the expanded affiliated group. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
(6) Allocation of income and loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
(i) Pro rata allocation method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
(ii) Closing of the books method.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
(iii) Making the § 199 closing of the books election. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
(b) Coordination with rules relating to the allocation of income under § 1.1502–76(b). . . . . . . . . . . . . . . . 525
(7) Total § 199 deduction for a corporation that is a member of an expanded affiliated group for some or all of
its taxable year.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
(8) Computation of § 199 deduction for members of expanded affiliated group with different taxable years. . . . 526
.10 Trade or Business Requirement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526
.11 Coordination with Alternative Minimum Tax. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526
.12 Special rules. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526
(1) Certain nonrecognition transactions.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526
(2) Section 1031 exchanges.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526
(3) Section 381 transactions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526
(4) Taxpayers with a 52–53 week taxable year. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526

SECTION 5. EFFECTIVE DATE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526

SECTION 6. REQUEST FOR COMMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526


.01 In General. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526
.02 Addresses for Comments.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 527
.03 Deadline for Submission of Comments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 527

SECTION 7. DRAFTING INFORMATION. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 527

SECTION 1. PURPOSE 2007, 2008, or 2009) of the lesser of (a) losses directly allocable to such receipts;
the qualified production activities income and (c) a ratable portion of deductions, ex-
The Internal Revenue Service and (QPAI) of the taxpayer for the taxable penses, and losses not directly allocable to
Treasury Department currently are de- year, or (b) taxable income (determined such receipts or another class of income.
veloping regulations under § 199 of the without regard to § 199) for the taxable (2) Section 199(c)(2) provides that
Internal Revenue Code, enacted as part of year (or, in the case of an individual, under the Secretary shall prescribe rules for the
the American Jobs Creation Act of 2004, § 199(d)(2), adjusted gross income). proper allocation of items of income, de-
Pub. L. No. 108–357 (the Act), regarding (2) Section 199(b)(1) limits the deduc- duction, expense, and loss for purposes of
the deduction relating to income attrib- tion for a taxable year to 50 percent of the determining QPAI.
utable to domestic production activities. W–2 wages paid by the taxpayer during (3) Section 199(c)(3) provides special
This notice provides interim guidance on the calendar year that ends in such taxable rules for determining costs in computing
which taxpayers may rely until the regula- year. For this purpose, § 199(b)(2) defines QPAI. Under these special rules, any item
tions are issued. The Service and Treasury the term “W–2 wages” to mean the sum or service brought into the United States
Department expect that the regulations of the aggregate amounts the taxpayer is is treated as acquired by purchase, and its
will incorporate the rules set forth in this required under § 6051(a)(3) and (8) to in- cost is treated as not less than its value im-
notice and will be effective for taxable clude on the Forms W–2 of the taxpayer’s mediately after it enters the United States.
years beginning after December 31, 2004, employees during the calendar year ending A similar rule applies in determining the
the effective date of § 199. See § 102(e) during the taxpayer’s taxable year. Sec- adjusted basis of leased or rented prop-
of the Act. This notice requests comments tion 199(b)(3) provides that the Secretary erty when the lease or rental gives rise
on the interim guidance provided herein shall prescribe rules for the application of to DPGR. If the property has been ex-
and any additional guidance that should be § 199(b) in the case of an acquisition or ported by the taxpayer for further manu-
provided in regulations. Comments must disposition of a major portion of either a facture, the increase in cost or adjusted ba-
be received by March 31, 2005. trade or business or a separate unit of a sis must not exceed the difference between
trade or business during the taxable year. the value of the property when exported
SECTION 2. OVERVIEW OF § 199
.02 Qualified Production Activities In- and its value when brought back into the
.01 In General. (1) Section 199(a)(1) come. (1) Under § 199(c)(1), QPAI is the United States after further manufacture.
allows a deduction equal to 9 percent excess of domestic production gross re- (4) Section 199(c)(4)(A) defines DPGR
(3 percent in the case of taxable years be- ceipts (DPGR) over the sum of: (a) the cost to mean the taxpayer’s gross receipts that
ginning in 2005 and 2006, and 6 percent of goods sold (CGS) allocable to such re- are derived from: (a) any lease, rental,
in the case of taxable years beginning in ceipts; (b) other deductions, expenses, or license, sale, exchange, or other disposi-

2005–7 I.R.B. 502 February 14, 2005


tion of (i) qualifying production property partner, or similar level, except as oth- the taxable income of the cooperative un-
(QPP) that was manufactured, produced, erwise provided in rules applicable to der § 1382.
grown, or extracted (MPGE) by the tax- individuals and patrons of cooperatives. (2) In determining the portion of the co-
payer in whole or in significant part within Section 199(d)(1) further provides that the operative’s QPAI that would be deductible
the United States; (ii) any qualified film Secretary shall prescribe rules for the ap- by the cooperative, the cooperative’s tax-
produced by the taxpayer; or (iii) elec- plication of § 199, including rules relating able income is computed without taking
tricity, natural gas, or potable water pro- to: (a) restrictions on the allocation of the into account any deduction allowable un-
duced by the taxpayer in the United States; deduction to taxpayers at the partner or der § 1382(b) or (c) (relating to patron-
(b) construction performed in the United similar level; and (b) additional reporting age dividends, per-unit retain allocations,
States; or (c) engineering or architectural requirements. and nonpatronage distributions) and, in the
services performed in the United States for (2) Notwithstanding the general rule case of a cooperative engaged in marketing
construction projects in the United States. that § 199 is applied at the shareholder, agricultural and horticultural products, the
Section 199(c)(4)(B) excepts from DPGR partner, or similar level, § 199(d)(1)(B) cooperative is treated as having MPGE, in
gross receipts of the taxpayer that are de- provides that, for purposes of applying the whole or in significant part, any QPP mar-
rived from: (a) the sale of food and bev- wage limitation of § 199(b), a shareholder, keted by the cooperative that its patrons
erages prepared by the taxpayer at a retail partner, or similar person that is allocated have MPGE.
establishment; and (b) the transmission or QPAI from an S corporation, partnership, .06 Expanded Affiliated Groups. (1)
distribution of electricity, natural gas, or estate, trust, or other pass-thru entity is Section 199(d)(4)(A) provides that all
potable water. also treated as having been allocated W–2 members of an expanded affiliated group
(5) Section 199(c)(5) defines QPP to wages from such entity in an amount equal (EAG) are treated as a single corpo-
mean: (a) tangible personal property; (b) to the lesser of: (i) such person’s allocable ration for purposes of § 199. Section
any computer software; and (c) any prop- share of such wages (without regard to 199(d)(4)(B) provides that an EAG is an
erty described in § 168(f)(4) (certain sound this rule) as determined under regulations affiliated group as defined in § 1504(a),
recordings). prescribed by the Secretary; or (ii) 2 times determined by substituting “50 percent”
(6) Section 199(c)(6) defines a quali- 9 percent (3 percent in the case of taxable for “80 percent” each place it appears, and
fied film to mean any property described years beginning in 2005 and 2006, and 6 without regard to § 1504(b)(2) and (4).
in § 168(f)(3) if not less than 50 percent of percent in the case of taxable years begin- (2) Section 199(d)(4)(C) provides that,
the total compensation relating to produc- ning in 2007, 2008, or 2009) of the QPAI except as provided in regulations, the § 199
tion of the property is compensation for allocated to such person for the taxable deduction is allocated among the members
services performed in the United States year. of the EAG in proportion to each mem-
by actors, production personnel, directors, .04 Individuals. In the case of individ- ber’s respective amount (if any) of QPAI.
and producers. The term does not include uals, § 199(d)(2) provides that the deduc- .07 Trade or Business Requirement.
property with respect to which records tion is equal to the applicable percent of the Section 199(d)(5) provides that § 199 is
are required to be maintained under 18 lesser of the taxpayer’s (1) QPAI for the applied by taking into account only items
U.S.C. § 2257 (generally, films, video- taxable year, or (2) adjusted gross income that are attributable to the actual conduct
tapes, or other matter that depict actual (AGI) for the taxable year determined after of a trade or business.
sexually explicit conduct and are pro- applying §§ 86, 135, 137, 219, 221, 222, .08 Alternative Minimum Tax. Sec-
duced in whole or in part with materials and 469, and without regard to § 199. tion 199(d)(6) provides rules to coordinate
that have been mailed or shipped in inter- .05 Patrons of Certain Cooperatives. the deduction allowed under § 199 with the
state or foreign commerce, or are shipped (1) Section 199(d)(3) provides special alternative minimum tax (AMT) imposed
or transported or are intended for shipment rules under which a taxpayer receiving by § 55. The deduction is allowed for
or transportation in interstate or foreign certain patronage dividends or certain purposes of the AMT, except that the de-
commerce). qualified per-unit retain allocations from duction is equal to the applicable percent
(7) Section 199(c)(7) provides that a cooperative (to which subchapter T ap- of the lesser of the taxpayer’s: (1) QPAI,
DPGR does not include any gross receipts plies) engaged in the MPGE, in whole or determined without regard to subchapter
of the taxpayer derived from property in significant part, or in the marketing, of A, Part IV, of the Code; or (2) alternative
leased, licensed, or rented by the taxpayer any agricultural or horticultural product minimum taxable income (AMTI). For
for use by any related person. A person is is allowed a deduction under § 199 with purposes of the preceding sentence, in the
treated as related to another person if both respect to the amount of the patronage case of an individual, AGI (determined
persons are treated as a single employer dividends or qualified per-unit retain allo- without regard to § 199) shall be substi-
under either § 52(a) or (b) (without regard cations that are: (a) allocable to the portion tuted for AMTI.
to § 1563(b)), or § 414(m) or (o). of the cooperative’s QPAI that would be .09 Authority to Prescribe Regulations.
.03 Pass-thru Entities. (1) Sec- deductible by the cooperative; and (b) Section 199(d)(7) authorizes the Secretary
tion 199(d)(1) provides that, in the case designated as such by the cooperative in a to prescribe such regulations as are neces-
of an S corporation, partnership, estate written notice mailed to its patrons during sary to carry out the purposes of § 199.
or trust, or other pass-thru entity, § 199 the payment period described in § 1382.
generally is applied at the shareholder, Such an amount, however, does not reduce

February 14, 2005 503 2005–7 I.R.B.


SECTION 3. EXPLANATION OF (3) Acquisitions and dispositions of a taxpayer’s W–2 wages under § 199(b)(2)
INTERIM GUIDANCE trade or business (or major portion). Sec- the lesser of (A) the total entries in Box
tion 4.02(1)(d) of this notice provides that 1 of all Forms W–2 filed with the Social
.01 In General. Section 199 provides a if a taxpayer (the successor) acquires the Security Administration (SSA) by the tax-
deduction from gross income for an appli- major portion of a trade or business or the payer with respect to employees of the tax-
cable percentage of QPAI subject to cer- major portion of a separate unit of a trade payer or (B) the total entries in Box 5 of
tain limits. Section 199 raises a num- or business from another taxpayer (the pre- all Forms W–2 filed with the SSA by the
ber of complex issues. In general, the in- decessor), the successor may not take into taxpayer with respect to employees of the
terim guidance provided in this notice is account wages paid to common law em- taxpayer. Under the second option, the
intended to balance the goals of: (1) ensur- ployees of the predecessor employer in re- W–2 wages are calculated by subtracting
ing compliance with the intent and purpose spect of services rendered to the prede- from the total amounts reported in Box 1 of
of § 199; and (2) providing clear, admin- cessor employer, even if those wages are Forms W–2 with respect to employees of
istrable rules that minimize, to the extent reported on Forms W–2 furnished by the the taxpayer (1) amounts that are included
possible, the administrative burden on tax- successor. in Box 1 that are not wages under § 3401(a)
payers and the Service. (4) Non-duplication rule. Section and (2) items that are treated as wages un-
.02 Wage Limitation. (1) In general. 4.02(1)(e) of this notice includes a der § 3402(o) (for example, supplemen-
Section 4.02(1) of this notice provides non-duplication rule, which provides that tal unemployment compensation benefits),
rules that are used in determining the amounts that are treated as W–2 wages and then adding those elective deferrals
amount of “W–2 wages” of a taxpayer. for any taxable year may not be treated that are reported in Box 12 of Forms W–2
Section 4.02(1) provides that for purposes as W–2 wages for any other taxable year. with Codes D, E, F, G, and S. Under the
of § 199(b)(2), the term “taxpayer” means Thus, an amount of nonqualified deferred third option, a taxpayer may track the ac-
“employer.” Section 4.02(1) provides that compensation that is treated as W–2 wages tual amount of wages subject to federal
only amounts from Forms W–2, “Wage under the Unmodified Box Method in sec- income tax withholding, subtract supple-
and Tax Statement,” issued for employees tion 4.02(2)(b)(i) for a taxable year may mental unemployment compensation ben-
of the taxpayer for employment by the not be treated as W–2 wages in any other efits that were included in this amount, and
taxpayer are included in calculating this taxable year. then add specific elective deferrals that are
amount. For purposes of this calculation, (5) Definition of W–2 wages. (a) In reported in Box 12 of Forms W–2 with
employees of the taxpayer are limited to general. Section 4.02(2) of this no- Codes D, E, F, G, and S.
employees as defined by § 3121(d)(1) and tice provides rules for determining the .03 Determining Qualified Production
(d)(2) (that is, officers of a corporate tax- “W–2 wages” of a taxpayer. The term Activities Income. Section 4.03 of this no-
payer and employees of the taxpayer under “W–2 wages” includes amounts that are tice provides rules for determining a tax-
the common law rules). Section 4.02(1)(b) required to be included on statements payer’s QPAI for the taxable year. This
provides generally that any discussion of under § 6051(a)(3) and (8) with respect notice provides that QPAI is determined
the term “wages” in this notice is solely to employees of the taxpayer. Because on an item-by-item basis (and not, for ex-
for purposes of § 199 and has no appli- § 6051(a)(3) and (8) include the total ample, on a division-by-division, a prod-
cation in determining whether amounts amount of wages as defined in § 3401(a), uct line-by-product line, or a transaction-
are wages for purposes of the Federal the total amount of elective deferrals by-transaction basis) and is the sum of
Insurance Contributions Act (FICA), the (within the meaning of § 402(g)(3)), the the QPAI derived by the taxpayer from
Federal Unemployment Tax Act (FUTA), compensation deferred under § 457, and each item. For purposes of this determi-
federal income tax withholding, or any (for tax years beginning after December nation, QPAI from each item may be pos-
other wage related determination. 31, 2005) the amount of designated Roth itive or negative. Section 4.04 provides
(2) Wages paid by other entities. Sec- contributions (as defined in § 402A), there rules for determining a taxpayer’s DPGR,
tion 4.02(1) of this notice provides that is no single box on the Form W–2 that the definition of the terms “gross receipts,”
a taxpayer may take into account wages necessarily includes all these items of in- “manufactured, produced, grown, or ex-
paid and reported by other entities to em- formation without including other items. tracted,” “by the taxpayer,” “in whole or
ployees of that taxpayer for employment Therefore, no single box on the Form W–2 in significant part,” and “derived from the
by that taxpayer. Thus, a taxpayer may meets the § 199(b)(2) definition of W–2 lease, rental, license, sale, exchange, or
take into account wages paid by agents wages. other disposition of qualifying production
of the taxpayer on behalf of the taxpayer (b) Methods for calculating W–2 wages. property,” as well as rules for determin-
to employees of the taxpayer that are in- Because no single box on Form W–2 sat- ing whether property qualifies as QPP (that
cluded on Forms W–2 issued by the agent. isfies the definition of W–2 wages under is, tangible personal property, computer
A taxpayer also may take into account § 199(b)(2), section 4.02(2)(b) of this no- software, and sound recordings). See sec-
wages paid by a person defined as an em- tice provides three alternative methods for tion 3.04 for an explanation of these rules.
ployer under § 3401(d)(1), to employees calculating W–2 wages only for purposes Section 4.05 provides rules for determin-
of the taxpayer if the wages are included of § 199. The first option allows for a sim- ing a taxpayer’s costs (including CGS) for
on Forms W–2 issued by the § 3401(d)(1) plified calculation while the last two op- purposes of computing QPAI. See section
employer. tions provide greater accuracy. Under the 3.05 for an explanation of the rules relat-
first option, a taxpayer may treat as the ing to costs. Generally, if a taxpayer is

2005–7 I.R.B. 504 February 14, 2005


engaged exclusively in the manufacture of the method is used by the taxpayer for § 199 to be available to taxpayers for a
QPP within the United States and has no internal management or other business wide variety of production activities, sec-
other sources of income, it is anticipated purposes; whether the method is used for tion 4.04(3) of this notice defines MPGE
that QPAI will equal taxable income. other federal, state, or foreign income tax broadly to include all of the activities
.04 Determining Domestic Production purposes; the time, burden, and cost of specifically listed in §§ 199(c)(4)(A)(i)(I)
Gross Receipts. (1) In general. Section using various methods; and whether the and 263A(g)(1), and in §§ 1.48–1(d)(2)
4.04 of this notice generally provides rules taxpayer applies the method consistently and 1.263A–2(a)(1)(i) (hereinafter re-
for determining DPGR. A taxpayer must from year to year. For example, a tax- ferred to as “MPGE activities”). This
determine the portion of its total gross payer that uses a specific identification interpretation is solely for purposes of
receipts that are DPGR. For example, if method (that is, a method that specifically § 199, based on the authority provided to
a taxpayer manufactures QPP at a facility identifies where the item was MPGE) for the Secretary under § 199(d)(7), and does
inside the United States (that otherwise any other purpose is required to use that not affect the construction of these terms
qualifies under § 199) and QPP at a facil- method to determine DPGR. Similarly, a in other parts of the Code (for example,
ity outside the United States, the taxpayer taxpayer that has the information readily § 954(a)(1)(A)).
generally must determine the portion of its available to use a specific identification (b) Consistency with § 263A. The Ser-
gross receipts that are attributable to QPP method even if it does not use that method vice and Treasury Department believe
manufactured inside the United States and for any other purpose generally is required that the term “producer” has been inter-
the portion of its gross receipts that are to use a specific identification method to preted broadly under § 263A and includes
attributable to QPP manufactured outside determine DPGR and the taxpayer’s use within its scope all of the MPGE activities.
the United States to determine the tax- of a different, less accurate method to de- Accordingly, the Service and Treasury De-
payer’s DPGR. However, section 4.03(2) termine DPGR generally is not considered partment believe that if a taxpayer claims
provides a safe harbor under which a reasonable. However, a taxpayer that does it has MPGE QPP for the taxable year for
taxpayer with less than 5 percent of total not currently use a specific identification purposes of § 199(c)(4)(A)(i)(I), it is fun-
gross receipts from items other than DPGR method for any other purpose and does not damentally inconsistent for the taxpayer to
may treat all gross receipts as DPGR and have the information readily available to claim it is not a “producer” under § 263A
is therefore not required to allocate its use the method generally is not required to with respect to the QPP for the taxable
gross receipts. For example, interest use that method to determine DPGR. See year. Therefore, section 4.04(3)(b) of this
and late fees relating to QPP manufac- section 3.05 for an explanation of rules notice provides that a taxpayer that has
tured in the United States by a taxpayer relating to the allocation of costs. MPGE QPP for the taxable year should
and sold by the taxpayer on credit are (2) Definition of “gross receipts.” For also consistently treat itself as a producer
not DPGR, but may be treated as DPGR purposes of § 199, section 4.04(2) of this under § 263A with respect to the QPP
if the taxpayer’s interest and late fees, notice defines the term “gross receipts” us- for the taxable year unless the taxpayer
when aggregated with other non-DPGR, ing a definition that is derived from the is not subject to § 263A under the Code,
are collectively less than 5 percent of definition under § 1.448–1T(f)(2)(iv)(A). regulations, or other published guidance.
the taxpayer’s total gross receipts. The In general, “gross receipts” for the taxable Taxpayers that currently are not properly
Service and Treasury Department do not year are those that are properly recognized accounting for their production activities
believe that the interim guidance should under the taxpayer’s accounting method under § 263A, and that wish to change
mandate a single method of determining for federal income tax purposes. their method of accounting to comply
DPGR because the Service and Treasury (3) Definition of “manufactured, pro- with the producer requirements of § 263A,
Department have not identified a single duced, grown, or extracted.” (a) In general. must follow the procedures of Rev. Proc.
method that would be appropriate for all In determining how this notice should de- 97–27, 1997–1 C.B. 680 (as modified and
taxpayers. Accordingly, section 4.03(2) fine MPGE under § 199(c)(4)(A)(i)(I), the amplified by Rev. Proc. 2002–19, 2002–1
provides that a taxpayer’s method for de- Service and Treasury Department consid- C.B. 696, as amplified and clarified by
termining DPGR and non-DPGR must ered how those terms have been defined Rev. Proc. 2002–54, 2002–2 C.B. 432), or
be a reasonable method that accurately under § 954 (see § 1.954–3(a)(4)(i) for Rev. Proc. 2002–9, 2002–1 C.B. 327 (as
identifies the gross receipts derived from the definition of manufactured or pro- modified and clarified by Announcement
activities described in § 199(c)(4) based duced), and how the same or similar terms 2002–17, 2002–1 C.B. 561, modified and
on all of the information available to the have been defined for purposes of § 38 amplified by Rev. Proc. 2002–19, 2002–1
taxpayer to substantiate the allocation. (see § 1.48–1(d)(2)) and § 263A (see C.B. 696, and amplified, clarified, and
Among the factors that the Service will § 263A(g)(1) and § 1.263A–2(a)(1)(i)). modified by Rev. Proc. 2002–54, 2002–2
take into consideration in determining Even though these and similar terms are C.B. 432), whichever applies.
whether a taxpayer’s method is reasonable used in other parts of the Code, the Ser- (4) Definition of “by the taxpayer.”
is whether the taxpayer is using the most vice and Treasury Department believe that With the exception of the rules applicable
accurate information available to the tax- for this purpose the terms MPGE must be to an EAG, the Service and Treasury De-
payer; the relationship between the gross construed in light of the specific policies partment believe that the requirement of
receipts and the base chosen; the accu- underlying § 199. Because the Service § 199(c)(4)(A)(i) that property be MPGE
racy of the method chosen as compared and Treasury Department believe that “by the taxpayer” means that only one
with other possible methods; whether Congress intended for the deduction under taxpayer may claim the deduction under

February 14, 2005 505 2005–7 I.R.B.


§ 199 with respect to the same function rule for purposes of § 199. To illustrate of that QPP will be considered DPGR,
performed with respect to the same prop- this rule, if, in the example above, A owns regardless of whether the QPP is imported
erty. For example, if A enters into an the widgets during the period the quali- back into the United States prior to the
agreement with an unrelated customer B fying activity occurs (that is, A bears the lease, rental, license, sale, exchange, or
to manufacture 100 widgets for B, only benefits and burdens of ownership under other disposition of the QPP (and assum-
one of the taxpayers is treated as hav- federal income tax principles), the widgets ing all other requirements of § 199(c) are
ing MPGE the widgets for purposes of will be treated as manufactured by A and met). See section 4.04(7) of this notice for
§ 199(c)(4)(A)(i)(I). Section 4.04(4) of not the unrelated customer B for purposes a discussion of the definition of “derived
this notice provides that in contract man- of § 199(c)(4)(A)(i)(I). Conversely, if B is from the lease, rental, license, sale, ex-
ufacturing situations, if one taxpayer per- the owner of the widgets (that is, B bears change, or other disposition of qualifying
forms activities that constitute the MPGE the benefits and burdens under federal production property.”
of QPP or the production of a qualified income tax principles) during the period (b) Substantial in nature. Section
film, electricity, natural gas, or potable the qualifying activity occurs, the widgets 4.04(5)(b) of this notice provides, gener-
water (collectively “qualifying activity”) will be treated as manufactured by B, not ally, that the “in whole or in significant
pursuant to a contract with an unrelated A, for purposes of § 199(c)(4)(A)(i)(I). part” requirement is satisfied if the tax-
party, then only the taxpayer that has Under this rule, either A or B may qualify payer’s MPGE activity within the United
the benefits and burdens of ownership for the deduction, but both cannot obtain States with respect to the QPP is “sub-
of the property under federal income tax the benefit of the deduction for the same stantial in nature.” Whether a taxpayer’s
principles during the period the qualifying activity. No inference is intended concern- MPGE activity is “substantial in nature”
activity occurs is treated as engaging in the ing the definition of “by the taxpayer” or for purposes of § 199 generally depends
qualifying activity. This standard is based “contract manufacturing” for purposes of upon all of the facts and circumstances,
on the principles under § 936 and § 263A. any other provision of the Code. including the relative value added by, and
In considering which standard to apply in (5) Definition of “in whole or in sig- relative cost of, the taxpayer’s MPGE
contract manufacturing situations, the Ser- nificant part.” (a) In general. To qualify activity in the United States, the nature
vice and Treasury Department concluded for the § 199 deduction, QPP must be of the property, and the nature of the
that it is not appropriate to treat property MPGE “in whole or in significant part by MPGE activity that the taxpayer per-
as being manufactured by the customer the taxpayer within the United States.” forms in the United States. Although this
in a contract manufacturing situation if Under § 199, the gross receipts that are “substantial in nature” requirement ap-
the customer does not have the benefits considered DPGR are not limited to the plies on a facts and circumstances basis
and burdens of owning the property under gross receipts attributable to QPP MPGE like the “substantial in nature” require-
federal income tax principles during the entirely by a taxpayer. For example, if ment in § 1.954–3(a)(4)(iii), this “sub-
period the qualifying activity occurs. This a taxpayer purchases partially manufac- stantial in nature” requirement is not the
rule applies even if the customer exercises tured QPP from another taxpayer and same as the requirements underlying the
direct supervision and control over the the taxpayer satisfies the “in whole or “not the property which it purchased”
activities of the contractor or is treated in significant part” requirement with re- standard in § 1.954–3(a)(4). In partic-
as a producer of the property pursuant spect to the manufacture of the QPP, the ular, the substantial transformation test
to § 263A(g)(2) for other reasons. If a taxpayer’s gross receipts derived from of § 1.954–3(a)(4)(ii) is not relevant to
contractor does not have the benefits and the lease, rental, license, sale, exchange, the determination of “substantial in na-
burdens of owning the property under or other disposition of that QPP will be ture” for purposes of § 199(c)(4)(A)(i)(I).
federal income tax principles during the considered DPGR (assuming all other The Service and Treasury Department
period the qualifying activity occurs, the requirements of § 199(c) are met). Like- considered whether the general rule for
contractor is more appropriately viewed wise, if a taxpayer imports QPP that it determining whether the taxpayer satis-
as performing a service for the customer. partially manufactured outside the United fies the “in whole or in significant part”
As a result, a contractor that does not sat- States, and the taxpayer satisfies the “in requirement should be based upon a sin-
isfy the “by the taxpayer” requirements whole or in significant part” requirement gle, quantitative criterion, such as relative
of § 199(c)(4)(A)(i) is considered to be with respect to its United States manufac- value, or relative cost, of the United States
deriving gross receipts from the provi- turing activity associated with that QPP, activity. However, the Service and Trea-
sion of services and the receipts are not the taxpayer’s gross receipts derived from sury Department concluded that such a
considered to be “derived from any lease, the lease, rental, license, sale, exchange, general rule would not be suitable in all
rental, license, sale, exchange, or other or other disposition of that QPP will be circumstances. For example, assume that
disposition of ” the property within the considered DPGR (assuming all other re- a taxpayer purchases gemstones and pre-
meaning of § 199(c)(4)(A)(i) (see sec- quirements of § 199(c) are met). Similarly, cious metal and then uses these materials
tion 4.04(7)(a)). Thus, a taxpayer that if a taxpayer manufactures QPP in signifi- to produce jewelry in the United States
does not have the benefits and burdens of cant part in the United States and exports (for example, by cutting and polishing the
ownership of the property under federal the goods for further manufacture outside gemstones, melting and shaping the metal,
income tax principles during the period the United States, the taxpayer’s gross and combining the finished materials).
the qualifying activity occurs does not receipts derived from the lease, rental, li- The Service and Treasury Department
qualify under the contract manufacturing cense, sale, exchange, or other disposition believe that the taxpayer is properly re-

2005–7 I.R.B. 506 February 14, 2005


garded as manufacturing or producing the bel or the relative cost incurred by the tax- within the definition of United States,
QPP in significant part within the United payer with respect to the labeling activity. the term “United States” does not in-
States. The value added by the taxpayer’s In addition, the Service and Treasury De- clude possessions and territories of the
United States manufacturing, however, partment do not believe it is appropriate to United States or the airspace over the
may not be substantial when compared regard a taxpayer as meeting the “in whole United States and these areas for purposes
to the value of the final product because or in significant part” requirement if the of § 199. See, for example, § 638 and
of the relatively high value of the pur- taxpayer manufactures tangible personal § 301.7701(b)–1(c)(2)(ii).
chased materials. Similarly, the cost of the property entirely outside the United States, (7) Definition of “derived from the
taxpayer’s United States manufacturing even if the design and development activi- lease, rental, license, sale, exchange, or
may not be substantial when compared to ties that lead to the tangible personal prop- other disposition of qualifying production
the total cost of the product (and there- erty occur entirely within the United States property.” (a) In general. Section 4.04(7)
fore also may not meet the safe harbor because the design and development activ- of this notice provides that gross receipts
discussed below). However, the nature ities with respect to tangible personal prop- “derived from” an activity described in
of the product, and the nature of the tax- erty give rise to the creation of an intan- section 4.04(3) are limited to the direct
payer’s United States MPGE activity, is gible asset. Thus, with respect to tangible proceeds from the lease, rental, license,
such that the United States MPGE activity personal property, design and development sale, exchange, or other disposition of
is “substantial in nature.” Accordingly, the activities also are disregarded for purposes the QPP. Thus, for example, the “derived
Service and Treasury Department believe of the general “substantial in nature” test, from the sale of QPP” requirement is
that the “substantial in nature” test should and the costs of those activities are dis- met with respect to direct proceeds from
be applied by considering all of the facts regarded for purposes of the safe harbor the sale of QPP manufactured in whole
and circumstances. in section 4.04(5)(c) of this notice. How- or in significant part within the United
(c) Safe harbor. Section 4.04(5)(c) of ever, with respect to computer software States by a taxpayer for sale (assuming all
this notice provides a safe harbor under and sound recordings, intangible property other requirements of § 199(c) are met),
which a taxpayer will be treated as MPGE that may constitute QPP under § 199, the as well as for direct proceeds from the
property in whole or in significant part Service and Treasury Department believe sale of self-constructed QPP manufac-
within the United States if, in connection that a significant portion of the “produc- tured in whole or in significant part in the
with the property, conversion costs (direct tion” may be viewed as design and devel- United States by a taxpayer and used in
labor and related factory burden) to MPGE opment (for example, writing the program- the taxpayer’s trade or business (assum-
the property are incurred by the taxpayer ming code in the case of computer soft- ing all other requirements of § 199(c) are
within the United States and the costs ac- ware, and recording and editing the master met) (see section 3.05 for a discussion
count for 20 percent or more of the total copy in the case of sound recordings). Ac- of determining costs with respect to the
CGS of the property. This rule would op- cordingly, in the case of computer software disposition of self-constructed assets). In
erate similarly to the safe harbor provided and sound recordings, design and develop- addition, business interruption insurance
under § 1.954–3(a)(4)(iii) for determining ment activities are not disregarded for pur- and payments not to produce are treated
whether, for purposes of computing for- poses of applying the “substantial in na- as gross receipts “derived from the lease,
eign base company sales income, the sale ture” test and the costs of those activities rental, license, sale, exchange, or other
of property is treated as the sale of a man- are not disregarded for purposes of the safe disposition of ” an activity described in
ufactured product rather than the sale of a harbor in section 4.04(5)(c). section 4.04(7)(a) to the extent the pay-
component part, when purchased compo- (6) Definition of “United States.” ments are substitutes for gross receipts
nents constitute part of the property. Section 7701(a)(9) generally provides that would be so treated (assuming all
(d) Certain activities and costs disre- that, for purposes of the Code, the term other requirements of § 199(c) are met).
garded. The Service and Treasury De- “United States” when used in a geograph- Except as provided in section 4.04(7)(c)
partment believe that, in connection with ical sense includes only the 50 states and with respect to certain advertising income
the MPGE of QPP, packaging, repackag- the District of Columbia. For purposes of and section 4.04(7)(e) with respect to cer-
ing, labeling, and minor assembly opera- § 199, the term United States follows the tain oil and gas partnerships, the Service
tions should not be considered in apply- § 7701(a)(9) definition and includes the and Treasury Department believe that no
ing the general “substantial in nature” test, territorial waters of the United States and other receipts are within the language of
and that the costs of those activities should the seabed and subsoil of those submarine § 199(c)(4)(A)(i). For purposes of the
not be considered in applying the safe har- areas that are adjacent to the territorial wa- “derived from the lease, rental, license,
bor. This rule is similar to the test ap- ters of the United States and over which sale, exchange, or other disposition of ”
plied in § 1.954–3(a)(4)(iii). For exam- the United States has exclusive rights, in requirement of § 199(c)(4)(A)(i), existing
ple, a taxpayer whose United States activ- accordance with international law, with federal income tax law principles apply
ities consist solely of affixing a label to a respect to the exploration and exploitation to determine whether a transaction is, in
plastic bottle otherwise manufactured en- of natural resources. However, because substance, a lease, rental, license, sale,
tirely outside the United States will not be neither § 199 nor the legislative history exchange or other disposition, or whether
regarded as having met the “in whole or explicitly include possessions and territo- it is a service. See for example, Rev.
in significant part” requirement, regardless ries of the United States or the airspace Rul 88–65, 1988–2 C.B. 32, which treats
of the value added to the bottle by the la- over the United States and these areas a short-term rental as a service. For an

February 14, 2005 507 2005–7 I.R.B.


explanation of the rules relating to de- percent de minimis rule is consistent with gross receipts derived by a taxpayer from
termining gross receipts “derived from” § 1.451–5(a)(3), which generally provides software that is merely offered for use to
construction performed in the United that if less than 5 percent of an advance customers online for a fee are not DPGR.
States, see section 3.04(11)(e). payment for goods is allocable to the pro- In addition, gross receipts derived from the
(b) Allocation of gross receipts — em- vision of services, the portion so allocable lease, rental, license, sale, exchange, or
bedded services. With certain exceptions will be considered as an advance payment other disposition of computer software do
discussed below, gross receipts derived for goods. For purposes of applying this not include gross receipts derived from: (i)
from the performance of services do not de minimis rule, the gross receipts from a providing customer support in connection
qualify as DPGR. Accordingly, in the qualified warranty that are included in the with the sale of computer software; (ii) on-
case of the lease, rental, license, sale, ex- price charged for the lease, rental, license, line services; or (iii) providing Internet ac-
change, or other disposition of property sale, exchange, or other disposition of cess or telephone services over the Inter-
that contains a service element (embedded property are not treated as gross receipts net. These receipts are not DPGR because
service), section 4.04(7)(b) of this notice for services. these receipts are attributable to the provi-
generally requires that the taxpayer allo- (c) Advertising income. The Service sion of a service and are not derived from
cate the gross receipts (as well as the costs and Treasury Department believe that ad- the lease, rental, license, sale, exchange, or
— see section 4.05) between the property vertising income attributable to the sale other disposition of the software.
and the embedded service. The portion or other disposition of newspapers and (8) Definition of “qualifying produc-
of the gross receipts that are considered magazines should be considered “derived tion property.” (a) In general. Section
“derived from the lease, rental, license, from” the sale or other disposition of the 199(c)(5) provides that the term “qualify-
sale, exchange, or other disposition” of newspapers and magazines because the ing production property” includes: (1) tan-
the property may not exceed the selling advertising income is inextricably linked gible personal property; (2) computer soft-
price of the property without the service to the gross receipts derived from the lease, ware; and (3) sound recordings.
element. Section 4.04(7)(b) provides two rental, sale, exchange or other disposition (b) Tangible personal property. The
exceptions to the allocation requirement. of the newspapers and magazines. For definition of “tangible personal prop-
First, a taxpayer may include in DPGR example, a newspaper manufacturer’s re- erty” provided in section 4.04(8)(b) of
gross receipts from a qualified warranty ceipts from an advertiser to publish display this notice is derived primarily from,
(that is, a warranty that is provided in con- advertising or classified advertisements in and is generally consistent with, the def-
nection with the sale of QPP if (1) in the its newspaper are treated as gross receipts inition of that term under § 1.48–1(c).
normal course of its business, the charge derived from the sale of the newspapers Consistent with § 1.48–1(c), section
for the warranty is included in the price for purposes of § 199 (assuming all other 4.04(8)(b) provides that local law is
charged for the lease, rental, license, sale, requirements of § 199(c) are met). not controlling for purposes of deter-
exchange, or other disposition of the QPP (d) Computer software. The determina- mining whether property is tangible per-
and (2) the warranty is neither separately tion of whether a transfer of computer soft- sonal property under § 199(c)(5)(A). In
offered by the taxpayer nor separately bar- ware is a sale or exchange of property, a li- addition to many of the items specifi-
gained for with the customer (that is, the cense generating royalty income, or a lease cally referenced in § 1.48–1(c), section
customer cannot purchase the QPP without generating rental income is made taking 4.04(8)(b) includes in the term “tangible
the warranty)). This exception is consis- into account all facts and circumstances. personal property” videocassettes, com-
tent with a similar exception provided in The form adopted by the parties to a trans- puter diskettes, books, and similar items.
section 3.07 of Rev. Proc. 71–21, 1971–2 action, the classification of the transac- See § 1.263A–2(a)(2)(ii). No inference
C.B. 549 (modified and superseded by tion under copyright law, and the physical is intended concerning whether these
Rev. Proc. 2004–34, 2004–22 I.R.B. or electronic or other medium used to ef- items are tangible or intangible property
991), regarding the deferral of certain ad- fectuate the transfer of computer software for purposes of any other section of the
vance payments for services. Second, a are not determinative. See § 1.861–18. Code (for example, § 197). Treating these
de minimis amount of gross receipts from A service provided using computer soft- items as tangible personal property is con-
embedded services for each item of prop- ware that does not involve a transfer of the sistent with the definitions provided for
erty may qualify as DPGR. A de minimis computer software does not result in gross “computer software,” “sound recordings,”
amount of gross receipts from embedded receipts that are derived from the lease, and “qualified films,” that do not include
services is equal to less than 5 percent of rental, license, sale, exchange, or other dis- the tangible personal property (if any) in
the gross receipts of the property. If one of position of computer software. Thus, with which computer software, a sound record-
these exceptions is met, the gross receipts respect to computer software that is de- ing, or a qualified film is fixed. As a result,
derived from the lease, rental, license, sale, veloped in the United States and sold to “tangible personal property” excludes any
exchange, or other disposition of property customers who take delivery of the soft- property that falls within the definition of
and the gross receipts from the embedded ware by downloading the software from computer software, a sound recording, or
services are treated as “derived from the the Internet, the manufacturer’s gross re- a qualified film. For example, a sale of a
lease, rental, license, sale, exchange, or ceipts from the sales are DPGR (assuming computer game on a CD-ROM has both
other disposition” of the property and are all other requirements of § 199(c) are met). a tangible personal property element (the
treated as DPGR (assuming all other re- Except as provided in the safe harbor de- disc) and a computer software element
quirements of § 199(c) are met). The 5 scribed in section 3.04(7)(b) of this notice, (the program fixed on the disc), but a sale

2005–7 I.R.B. 508 February 14, 2005


of the same program effected instead by software (which are not DPGR because duces a qualified film, fixes the film to a
an internet download involves computer the software was developed outside the tangible medium purchased from an unre-
software only. United States) and those attributable to the lated taxpayer, and leases or licenses the
(c) Computer software. (i) In general. compact discs (which are DPGR, assum- qualified film and medium containing the
The definition of “computer software” ing all other requirements of § 199(c) are qualified film to unrelated commercial the-
provided in section 4.04(8)(c) of this no- met). aters, A’s gross receipts from the lease or
tice is derived from the definition of that (d) Sound recordings. Section 199(c) license of the qualified film are “derived
term under § 1.197–2(c)(4)(iv), but also (5)(C) provides that QPP includes any from” (i) the lease of tangible personal
includes the machine-readable coding for property described in § 168(f)(4). Sec- property (the tangible medium on which
video games and similar programs, regard- tion 4.04(8)(d) of this notice defines the the copy is fixed), that are not DPGR, and
less of whether the program is designed to term “sound recording” consistent with (ii) the license of the qualified film (the
operate on a “computer” (as defined under § 168(f)(4). Consistent with the defini- right to publicly display the film), that are
§ 168(i)(2)(B)). The term “computer soft- tions of computer software and qualified DPGR. If, instead, A licenses a qualified
ware” includes all property described in films, the definition of “sound recording” film to unrelated taxpayer B, and B re-
section 4.04(8)(c). Thus, DPGR includes does not include tangible personal prop- produces the film on DVDs or videocas-
the gross receipts from computer software erty in which the sound recording is fixed, settes manufactured by B in the United
that was developed by the taxpayer, pro- such as a compact disc. This interpre- States, B’s gross receipts from the sale
vided the gross receipts are derived from tation does not affect any other section of the DVDs and videocassettes are “de-
the lease, rental, license, sale, exchange, of the Code (for example, § 168(f)(4)). rived from” the sale of (i) tangible per-
or other disposition of computer software Consequently, the results in the examples sonal property (the DVDs and videocas-
as required by § 199(c)(4)(A)(i). provided in section 3.04(8)(c)(ii) would settes), that are DPGR, and (ii) the quali-
(ii) Tangible personal property not in- be the same if, instead of software, the ex- fied film (the motion picture fixed on the
cluded. “Computer software” does not amples involved the production of sound DVDs and cassettes), that are not DPGR.
include diskettes or other tangible prop- recordings and compact discs that contain A taxpayer that merely writes a screenplay
erty on which machine-readable coding the sound recordings. or other similar material is not considered
is placed, as the property is considered (9) Definition of “qualified film.” (a) to have produced a qualified film under
tangible personal property for purposes In general. Section 199(c)(6) provides § 199(c)(4)(A)(i)(II). Therefore, amounts
of § 199. For example, assume B, who that the term “qualified film” means any that a taxpayer receives from the sale of a
is unrelated to A, develops software out- property described in § 168(f)(3). Ac- script or screenplay, even if it is developed
side the United States and licenses the cordingly, section 4.04(9) of this notice into a qualified film, are not gross receipts
rights to manufacture and distribute the defines a “qualified film” to include any “derived from” a qualified film. In addi-
software to A, and A manufactures in motion picture film or video tape (other tion, revenue from the sale of film-themed
the United States compact discs encoded than certain sexually explicit visual depic- merchandise is revenue from the sale of
with the software. Assume further that A tions), as well as live or delayed televi- tangible personal property, and not gross
sells the compact discs encoded with the sion programming (see H.R. Conf. Rep. receipts “derived from” a qualified film.
software. A’s gross receipts from the sale No. 755, 108th Cong., 2d Sess. 273 Finally, gross receipts derived from a li-
of the compact discs are derived in part (fn. 30) (2004) (Conference Report) (here- cense of the right to use the film charac-
from the sale of tangible personal property inafter referred to collectively as “film”) ters are not gross receipts “derived from”
(the compact discs), and in part from the if not less than 50 percent of the total a qualified film.
sale of computer software. Therefore, A compensation relating to the production of (b) Production personnel. For purposes
must allocate its gross receipts between the property is compensation for services of § 199(c)(6), the term “production per-
those attributable to the software (which performed in the United States by actors, sonnel” includes all personnel (other than
are not DPGR) and those attributable to production personnel, directors, and pro- actors, directors, and producers) who are
the compact discs (which are DPGR, as- ducers. Qualified films include all prop- directly involved in the production of the
suming all other requirements of § 199(c) erty described in section 4.04(9). Consis- film. Thus, “production personnel” un-
are met). Assume in the alternative that tent with the definitions of “computer soft- der section 4.04(9)(a) of this notice in-
A is an integrated software developer and ware” and “sound recordings,” the defini- clude writers, choreographers and com-
producer that designs the software outside tion of “qualified film” is limited to the posers providing services during the pro-
the United States and manufactures the master copy of the film (or other copy duction of a film, casting agents, camera
compact discs within the United States. from which the holder is licensed to make operators, set designers, lighting techni-
Assume further that A sells the compact and produce copies), and does not include cians, make-up artists, and others whose
discs encoded with the software. A’s gross tangible personal property embodying the activities are directly related to the produc-
receipts from the sale of the compact discs qualified film, such as DVDs or videocas- tion of the film. “Production personnel” do
are derived in part from the sale of tangi- settes. This interpretation does not affect not include, however, individuals whose
ble personal property (the compact discs), any other section of the Code (for exam- activities are ancillary to the production,
and in part from the sale of computer soft- ple, § 168(f)(3)). In no event will ticket such as advertisers and promoters, distrib-
ware. Therefore, A must allocate its gross sales for viewing qualified films consti- utors, studio administrators and managers,
receipts between those attributable to the tute DPGR. Thus, for example, if A pro-

February 14, 2005 509 2005–7 I.R.B.


studio security personnel, and personal as- However, if less than 5 percent of a tax- no allocation between the production and
sistants to actors. payer’s gross receipts derived from a sale distribution of the bottled potable water is
(c) Compensation for services. Under of electricity, natural gas, or potable water required.
section 4.04(9)(b) of this notice, compen- are attributable to the transmission and (11) Definition of “construction per-
sation for services includes all payments distribution of such electricity, natural gas, formed in the United States.” (a) Construc-
for services performed by actors, produc- or potable water, then the gross receipts tion of real property. Section 4.04(11)(a)
tion personnel, directors, and producers, derived from that sale that are attributable of this notice defines the term “construc-
including participations and residuals. See to the transmission and distribution of tion” under § 199(c)(4)(A)(ii) to mean the
Conference Report at 273 (fn. 31). In the such items will be treated for purposes of construction of real property (that is, resi-
case of a taxpayer that uses the income § 199 as being DPGR. dential and commercial buildings (includ-
forecast method of § 167(g) and capi- (b) Natural gas. Section 4.04(10)(b) of ing items that are structural components
talizes participations and residuals into this notice defines the term “natural gas” of such buildings), inherently permanent
the adjusted basis of the qualified film, in a manner consistent with § 613A(e)(2) structures other than tangible property in
the taxpayer must use the same estimate and generally includes only natural gas the nature of machinery, inherently perma-
of participations and residuals for pur- extracted from a natural deposit. Thus, nent land improvements, and infrastruc-
poses of § 199 that it uses for purposes of natural gas would not include, for exam- ture). Section 4.04(11)(a) makes clear that
§ 167(g). In the case of a taxpayer that ple, methane gas extracted from a land- local law is not controlling for purposes
excludes participations and residuals from fill. Consistent with the Conference Re- of determining whether or not property is
adjusted basis of the qualified film under port at 272–3 (fn. 28), section 4.04(10)(b) real property for purposes of “construc-
§ 167(g)(7)(D)(i), the taxpayer must de- provides that, in the case of natural gas, tion” under § 199(c)(4)(A)(ii). See Con-
termine the compensation expected to be production activities include all activities ference Report at 271 (fn. 26). Tangible
paid as participations and residuals based involved in extracting natural gas from personal property (as defined under sec-
on the total forecasted income used in the ground and processing the gas into tion 4.04(8)(b)) (for example, appliances,
determining income forecast depreciation. pipeline quality gas. furniture and fixtures) that is sold as part
(d) Determination of 50 percent. The (c) Potable water. Section 4.04(10)(c) of a construction project is not considered
Service and Treasury Department do not of this notice provides that, consistent real property for this purpose. Under sec-
believe that a single method of allocating with the Conference Report at 272–3 tion 4.04(11)(a), however, if more than 95
compensation between services performed (fn. 28), production activities with respect percent of the total gross receipts derived
within the United States and services per- to potable water include the acquisition, by a taxpayer from a construction project
formed outside the United States is ap- collection, and storage of raw water (un- are attributable to real property (as defined
propriate for all taxpayers. Accordingly, treated water), transportation of raw water in § 1.263A–8(c)), the total gross receipts
section 4.04(9)(c) of this notice provides to a water treatment facility, and treat- derived by the taxpayer from the project
that a taxpayer may use any reasonable ment of raw water at such a facility. Thus, are DPGR from construction (assuming all
method of making the allocation. Among gross receipts derived from any of these other requirements of § 199 are met).
the factors to be considered in determining activities performed in the United States (b) Activities constituting construction.
whether a taxpayer’s method of allocating are included in DPGR (assuming all other The Service and Treasury Department
compensation is reasonable is whether the requirements of § 199(c) are met). DPGR believe the term “construction” includes
taxpayer uses that method consistently. does not include, however, gross receipts most activities that are typically performed
(10) Electricity, natural gas, and derived from the storage of potable wa- in connection with the erection or substan-
potable water. (a) In general. DPGR ter after completion of treatment of the tial renovation of real property, but does
includes gross receipts derived from any potable water, or delivery of potable water not include tangential services such as
lease, rental, license, sale, exchange, or to customers. The Service and Treasury hauling trash and debris, and delivering
other disposition of electricity, natural gas, Department believe that Congress in- materials, even if the tangential services
or potable water produced by the taxpayer tended for the provision relating to potable are essential for construction. However,
in the United States (assuming all other water to apply to water utilities, not to if a taxpayer performing construction
requirements of § 199(c) are met). DPGR taxpayers engaged in the trade or business also, in connection with the construction
does not include, however, gross receipts of producing bottled water. As a result, project, provides tangential services such
of the taxpayer derived from the transmis- for purposes of § 199 the production of as delivering materials to the construc-
sion or distribution of these items. The bottled water will be treated as the produc- tion site and removing its construction
Conference Report at 272–3 (fn. 28) ex- tion of tangible personal property under debris, the gross receipts derived from
plains that an integrated producer that both § 199(c)(5)(A) and not the production of such tangential services are DPGR. Im-
produces and delivers electricity, natural potable water under § 199(c)(4)(A)(i)(III). proving land (for example, grading and
gas, or potable water, must allocate its Accordingly, with respect to a taxpayer landscaping) and painting are activities
gross receipts between: (i) production that that produces bottled water in the United that are considered “construction,” but
qualifies as DPGR; and (ii) distribution States, the gross receipts from which only if they are performed in connection
and transmission (that do not qualify as would otherwise qualify as DPGR, DPGR with other activities (whether or not by the
DPGR). Thus, section 4.04(10)(d) of this also includes the gross receipts attributable same taxpayer) that constitute the erection
notice generally requires such allocation. to the distribution of the bottled water and or substantial renovation of real property.

2005–7 I.R.B. 510 February 14, 2005


The term “construction” does not include formed in the United States (assuming all the receipts will be treated as DPGR de-
any activity that is within the definition of other requirements of § 199(c) are met). rived from engineering or architectural
“engineering and architectural services” (ii) Taxpayers deriving gross receipts services performed in the United States
(see section 4.04(11)(b) of this notice). from construction. The Service and Trea- for a construction project in the United
(c) Definition of “infrastructure.” sury Department believe that it is appropri- States (assuming all other requirements of
The term “infrastructure,” for pur- ate, in certain situations, for more than one § 199(c) are met).
poses of § 199, includes roads, power taxpayer to be regarded as deriving gross (c) Construction projects within the
lines, water systems, railroad spurs, receipts from construction with respect to United States. Gross receipts from en-
and communications facilities. See the same activity and the same construc- gineering or architectural services that
§ 168(j)(4)(C)(ii). The term also includes tion project. For example, if X (who is otherwise would qualify as DPGR will
sewers, sidewalks, cable, and wiring. See not in the trade or business of construction not fail to qualify merely because the con-
§ 1.263A–12(e)(2)(iii). The term also in- and is the owner, under federal income tax struction project planned for the United
cludes inherently permanent oil and gas principles, of a building within the United States ultimately is not undertaken or com-
platforms. States) retains Y (a general contractor) to pleted.
(d) Definition of “substantial renova- oversee a “substantial renovation” of the (13) Exception for sales of certain food
tion.” The Service and Treasury Depart- building, and Y retains Z (a subcontrac- and beverages. Under § 199(c)(4)(B),
ment believe that the standard to be applied tor) to install a new electrical system in the DPGR does not include gross receipts de-
in determining whether there has been a building as part of that substantial renova- rived from the sale of food and beverages
substantial renovation of real property is tion, the amounts that Y receives from X, prepared by the taxpayer at a retail estab-
the standard applied under § 263(a) to de- and amounts that Z receives from Y, qual- lishment. For purposes of this rule, section
termine whether a taxpayer’s activities re- ify as DPGR. The proceeds that X receives 4.04(13) of this notice adopts a definition
sult in permanent improvements or bet- from the subsequent sale of the building do of “retail establishment” that is similar to
terments of property, such that the cost not qualify as DPGR because X did not en- the definition of “retail space” under § 110
of the activities must be capitalized. Ac- gage in any activity constituting construc- (regarding qualified lessee construction
cordingly, consistent with the rules under tion. allowances for short-term leases). Un-
§ 263(a), section 4.04(11)(d) of this notice (12) Definition of “engineering and ar- der this definition, a retail establishment
defines the term “substantial renovation” chitectural services.” (a) In general. The means real property leased, occupied, or
to mean the renovation of a major com- definitions provided in section 4.04(12) of otherwise used by the taxpayer in its trade
ponent or substantial structural part of real this notice of the terms “engineering ser- or business of selling food or beverages to
property that materially increases the value vices” and “architectural services” for pur- the public and at which the taxpayer makes
of the property, substantially prolongs the poses of § 199(c)(4)(A)(iii) are the same retail sales. Thus, a taxpayer’s facility is
useful life of the property, or adapts the as those provided in § 1.924(a)–1T(e)(5) not a retail establishment if the taxpayer
property to a new or different use. See and –1T(e)(6) without regard to the spe- only uses the facility to prepare food or
§ 263(a) and the regulations thereunder. cial rules of § 1.924(a)–1T(e)(2) and beverages for wholesale sale. However,
(e) “Derived from construction.” (i) In –1T(e)(3). Section 199(c)(4)(A)(iii) pro- under a safe harbor provided in section
general. Section 199(c)(4)(A)(ii) does not vides that such services must be performed 4.04(13), a facility at which food or bev-
provide that DPGR “derived from con- in the United States for a construction erages are prepared will not be treated as a
struction” performed in the United States project in the United States. This notice retail establishment if less than 5 percent
are gross receipts derived from “any lease, requires that: (1) the engineering or archi- of the total gross receipts of the taxpayer
rental, license, sale, exchange, or other tectural services relate to real property; (2) for the taxable year that are derived from
disposition of ” property. The Service and the services be performed in the United the sale of food or beverages prepared at
Treasury Department believe that gross States; and (3) the taxpayer providing the facility are attributable to retail sales
receipts from the rental of real property these services be able to substantiate that at the facility. If a taxpayer’s facility is
that the taxpayer constructs are not de- the services relate to a construction project a retail establishment, then as a matter
rived from construction, but are instead within the United States. of administrative grace, the Service and
compensation for the use or forbearance (b) Performance of services in the Treasury Department will permit the tax-
of the property. Accordingly, in the case United States. Section 4.04(12)(d) of payer to allocate its gross receipts between
of construction, DPGR does not include this notice provides a safe harbor under gross receipts derived from the retail sale
gross receipts from the lease or rental which, if, in connection with a construc- of the food and beverages prepared and
of constructed real property. However, tion project in the United States, the gross sold at the retail establishment (which are
DPGR may include the proceeds of a receipts derived from engineering or ar- non-DPGR) and gross receipts derived
sale, exchange, or other disposition of real chitectural services (1) performed outside from the wholesale sale of the food and
property constructed in the United States the United States or (2) related to prop- beverages prepared at the retail establish-
(whether or not the property is sold im- erty other than real property are less than ment (which are DPGR).
mediately after construction is completed) 5 percent of the total gross receipts de- .05 Determining Costs. (1) In general.
if all other requirements of § 199(c) are rived from engineering or architectural To determine its QPAI for the taxable
met. DPGR also includes compensation services performed by the taxpayer with year, a taxpayer must reduce its DPGR
received for construction services per- respect to the same construction project, by the amount of CGS directly allocable

February 14, 2005 511 2005–7 I.R.B.


to DPGR, the amount of deductions, ex- vided by §§ 1.861–8 through 1.861–17 or the small business simplified overall
penses, and losses (deductions) directly and §§ 1.861–8T through 1.861–14T (the method is determined by reference to the
allocable to DPGR and a ratable portion § 861 regulations) subject to the provisions average annual gross receipts of the EAG.
of other deductions not directly alloca- of this notice. This notice provides special To compute the average annual gross re-
ble to DPGR, or another class of income. rules for apportioning certain charitable ceipts of an EAG, the gross receipts of
Section 199(c)(2) directs the Secretary to deductions and research and experimenta- each member of the EAG for its taxable
prescribe rules for the proper allocation tion deductions. The Service and Treasury year that ends with or within the taxable
of these items. The legislative history of Department recognize that these allo- year of the member that is computing its
§ 199 indicates that, when appropriate, cation and apportionment rules may be § 199 deduction are aggregated, regardless
these rules should be similar to, and con- burdensome to certain taxpayers that oth- of whether the computing member or the
sistent with, the relevant cost allocation erwise would not be required to use these non-computing member was a member of
rules provided by §§ 263A and 861. A rules, particularly for taxpayers that are the EAG during its entire taxable year. A
taxpayer’s costs must be determined us- not currently using the section 861 cost member of an EAG that qualifies to use
ing the taxpayer’s accounting method for allocation regime. Accordingly, section the simplified deduction method or the
federal income tax purposes. Section 4.05 4.05 provides two alternative apportion- small business simplified overall method
of this notice provides rules for determin- ment methods for certain taxpayers, with may do so only if all members of the EAG
ing CGS directly allocable to DPGR and a goal of minimizing the need for smaller agree to and use the same method.
rules to determine deductions allocated taxpayers to devote additional resources (b) Treatment of certain deductions.
and apportioned to DPGR. Pursuant to the to compliance. Any taxpayer with aver- Section 4.05(3)(b) of this notice clari-
authority granted by § 199(c)(2), the cost age annual gross receipts of $25,000,000 fies that certain deductions do not reduce
determination rules provided in section or less may use the simplified deduction DPGR or gross income attributable to
4.05 do not differentiate between deduc- method. Under the simplified deduction DPGR under any of the three methods. A
tions directly allocable to DPGR under method, a taxpayer’s deductions gen- loss generated by the sale of property re-
§ 199(c)(1)(B)(ii) and other deductions erally are ratably apportioned between duces DPGR or gross income attributable
that are not directly allocable to DPGR DPGR and other receipts based on rel- to DPGR only if the proceeds from the sale
or another class of gross income under ative gross receipts. The Service and of the property are, or would have been,
§ 199(c)(1)(B)(iii). Treasury Department invite comments on included in DPGR. A deduction allowed
(2) Allocation of cost of goods sold. the appropriateness of the gross receipts under § 172 for a net operating loss is
Section 4.05(2) of this notice provides threshold for use of the simplified deduc- not allocated or apportioned to DPGR or
rules for determining the CGS directly tion method. Alternatively, a qualifying gross income attributable to DPGR. Under
allocable to DPGR. Generally, CGS must small taxpayer may use the small business § 199(d)(5), deductions not attributable to
be specifically identified with, or directly simplified overall method to allocate CGS the actual conduct of a trade or business
traced to, DPGR in accordance with the and deductions to DPGR. A qualifying are not taken into account under § 199 and,
taxpayer’s books and records. However, small taxpayer is a taxpayer that has av- therefore, are not allocated or apportioned
if the taxpayer’s books and records do erage annual gross receipts of $5,000,000 to DPGR or gross income attributable to
not allow the taxpayer to identify the or less or a taxpayer that is eligible to use DPGR.
CGS directly allocable to DPGR, the tax- the cash method as provided in Rev. Proc. .06 Application of § 199 to Pass-thru
payer may use a reasonable method to 2002–28, 2002–1 C.B. 815. For purposes Entities. (1) In general. In the case of
allocate CGS between DPGR and other of the simplified deduction method and the an S corporation, partnership, estate or
gross receipts. If a method is used to al- small business simplified overall method, trust, or other pass-thru entity, § 199 is ap-
locate gross receipts between DPGR and a taxpayer meets the applicable average plied at the partner, shareholder or simi-
non-DPGR, the taxpayer may not use a annual gross receipts test if the average lar level. The Service and Treasury De-
different method for purposes of allocating annual gross receipts of the taxpayer for partment believe that Congress intended
CGS. For purposes of § 199, CGS includes the 3 taxable years (or, if fewer, the taxable § 199 to be applied in a manner consis-
the cost of inventoriable goods sold during years during which the taxpayer was in ex- tent with the economic arrangement of the
the year as well as the adjusted basis of istence) preceding the current taxable year owners of a pass-thru entity. The Service
noninventory property sold or exchanged do not exceed the applicable gross receipts and Treasury Department believe that this
during the year. threshold. Preceding taxable years are in- objective can be accomplished by allow-
(3) Allocation and apportionment of cluded even if one or more of such taxable ing each owner to compute its § 199 de-
deductions. (a) Three alternative meth- years began before the effective date of duction by taking into account its distribu-
ods. Section 4.05 of this notice pro- § 199. In the case of any taxable year of tive or proportionate share of the items (in-
vides three methods for allocating and less than 12 months (a short taxable year), cluding items of income, gain, loss, deduc-
apportioning deductions. Under the first the gross receipts must be annualized by tion, cost of goods sold allocated to such
method (the § 861 method), which is (a) multiplying the gross receipts for the items of income, and gross receipts that
available to all taxpayers, a taxpayer de- short period by 12 and (b) dividing the re- are included in such items of income) al-
termines the deductions allocated and sult by the number of months in the short located or attributable, in accordance with
apportioned to DPGR by applying the period. Whether the members of an EAG section 4.06 of this notice, to the pass-thru
allocation and apportionment rules pro- may use the simplified deduction method entity’s activities described in § 199(c)(4)

2005–7 I.R.B. 512 February 14, 2005


(qualified production activities), provided formation to its patrons to allow the pa- are disregarded in computing the EAG’s
the items are not otherwise disallowed by trons to compute the § 199 deduction. The § 199 deduction only to the extent pro-
the Code. For purposes of computing the Service and Treasury Department intend to vided in § 199(c)(7), if a transaction
§ 199(b) limitation, an owner’s share of provide rules relating to such information between members of an EAG is engaged
W–2 wages of a pass-thru entity is the reporting by cooperatives in future guid- in or structured with a principal purpose
lesser of the owner’s allocable share of the ance. of qualifying for, or modifying the amount
pass-thru entity’s W–2 wages or 2 times .08 Expanded Affiliated Groups. (1) of, the § 199 deduction for one or more
the applicable percentage of the owner’s In general. All members of an EAG are members of the EAG, adjustments must be
QPAI computed taking into account only treated as a single corporation for purposes made to eliminate the effect of the trans-
the items of the pass-thru entity allocated of § 199. An EAG is an affiliated group action on the computation of the § 199
to the owner for the taxable year. The as defined in § 1504(a), determined by deduction.
owner of the pass-thru entity will aggre- substituting “50 percent” for “80 percent” (3) Allocation of expanded affiliated
gate its items of income or expense (in- each place it appears, and without regard to group’s § 199 deduction. The EAG’s
cluding W–2 wages) allocated or attrib- § 1504(b)(2) and (4). Therefore, a single § 199 deduction is allocated among mem-
utable to the pass-thru entity’s qualified § 199 deduction is computed for the EAG bers of the EAG in proportion to each
production activities, including those ex- and then that deduction is allocated among member’s QPAI, if any, regardless of
penses incurred by the owner of the pass- members of the EAG. whether the EAG member has taxable
thru entity directly that are allocated to the (2) Computation of expanded affiliated income or loss for the taxable year and
pass-thru entity’s qualified production ac- group’s § 199 deduction. (a) In general. regardless of whether the EAG member
tivities, and the owner’s items of income or The Service and Treasury Department has W–2 wages for the taxable year. For
expense (including W–2 wages) allocated believe that the § 199 deduction of the this purpose, if a member has negative
or attributable to its other qualified produc- EAG must be computed by aggregating QPAI, the QPAI of the member shall be
tion activities. each member’s taxable income or loss, treated as zero.
(2) Gain or loss from the disposition of QPAI, and W–2 wages. For this purpose, (4) Special rules for consolidated
an interest in a pass-thru entity. Because a member’s QPAI is the member’s DPGR groups. The Service and Treasury Depart-
the sale of an interest in a pass-thru en- less the sum of the CGS allocable to the ment believe that, for purposes of § 199,
tity does not reflect the realization of QPAI receipts and other costs required to be if an EAG includes members of a consoli-
by that entity, QPAI generally does not in- allocated under section 4.05 of this no- dated group (as defined in § 1.1502–1(h)),
clude gain or loss recognized on the sale, tice. For purposes of this determination, a the members of the consolidated group
exchange or other disposition of an interest member’s QPAI may be positive or nega- should be treated as a single member of
in the entity. However, if § 751(a) or (b) tive. A member’s taxable income or loss the EAG. Therefore, if an EAG includes
applies, gain or loss allocated to assets of and QPAI shall be determined by reference corporations that are members of a con-
the partnership the sale, exchange, or other to the member’s methods of accounting. solidated group and corporations that are
disposition of which would give rise to an However, pursuant to § 199(c)(7)(A), a not members of a consolidated group, in
item of QPAI is taken into account in com- member’s DPGR shall not include any computing the taxable income limitation
puting the partner’s § 199 deduction. gross receipts of the member derived from of the EAG, the consolidated taxable in-
(3) Effective date of § 199 for pass-thru property leased, licensed, or rented by it come of the consolidated group, not the
entities. Section 199(e) provides that § 199 for use by any related person as defined in separate taxable income of the members
applies for taxable years beginning after § 199(c)(7)(B). of the consolidated group, is taken into
December 31, 2004. Accordingly, section (b) Attribution of activities. For pur- account. If all of the members of an EAG
4.06(3) of this notice provides that § 199 poses of determining whether gross re- are members of the same consolidated
only applies to taxable years of pass-thru ceipts are DPGR, the Service and Trea- group, the consolidated group’s § 199 de-
entities that begin on or after January 1, sury Department believe that each mem- duction is determined based on the group’s
2005. The Service and Treasury Depart- ber of an EAG should be treated as con- consolidated taxable income or loss, not
ment recognize that a pass-thru entity will ducting the activities conducted by each the separate taxable income or loss of its
need to provide certain information to its other member of the EAG. Thus, if Corpo- members. The § 199 deduction of a con-
owners to allow those persons to com- ration X and Corporation Y are members solidated group (or the § 199 deduction
pute the § 199 deduction. The Service of the same EAG and X manufactures QPP allocated to a consolidated group that is
and Treasury Department intend to provide in the United States and sells the QPP to Y a member of an EAG) must be allocated
rules relating to information reporting by and Y then sells the same item to an un- to the members of the consolidated group
pass-thru entities in future guidance. related party, X’s production activities are in proportion to each consolidated group
.07 Patrons of Agricultural and Horti- attributed to Y. Accordingly, the proceeds member’s QPAI, if any, regardless of
cultural Cooperatives. Section 4.07 of this of X’s sale to Y and Y’s sale to the unre- whether the consolidated group member
notice provides rules for the application of lated party are DPGR for X and Y, respec- has separate taxable income or loss for the
§ 199 to agricultural and horticultural co- tively (assuming all other requirements of taxable year and regardless of whether the
operatives and their patrons. The Service § 199 are met). member has W–2 wages for the taxable
and Treasury Department recognize that a (c) Anti-avoidance rule. Although year. For purposes of allocating the § 199
cooperative will need to provide certain in- transactions between members of an EAG deduction of a consolidated group among

February 14, 2005 513 2005–7 I.R.B.


its members, if a consolidated group mem- filiated group for some or all of its taxable endar year ending during the taxpayer’s
ber has negative QPAI, the QPAI of the year. If a corporation is a member of an taxable year for wages paid to employ-
member shall be treated as zero. EAG for its entire taxable year, the cor- ees (or former employees) of the taxpayer
(5) Identification of members of the ex- poration’s § 199 deduction for the taxable for employment by the taxpayer. For this
panded affiliated group. The Service and year is the amount of the § 199 deduction purpose and for purposes of section 4.02,
Treasury Department believe that whether of the EAG allocated to the corporation by employees of the taxpayer are limited to
a corporation is a member of an EAG must the EAG. If a corporation is a member of employees of the taxpayer as defined in
be determined on a daily basis. Therefore, an EAG for a portion of its taxable year, § 3121(d)(1) and (d)(2) (that is, officers
a corporation may be a member of an EAG and is either not a member of any EAG, or of a corporate taxpayer and employees of
on January 1 but not a member of the EAG is a member of another EAG, or both, for the taxpayer under the common law rules).
on January 2. If a corporation becomes or another portion of the taxable year, the cor- For purposes of § 199(b)(2), the term “tax-
ceases to be a member of an EAG, the cor- poration’s § 199 deduction for the taxable payer” means “employer.” In determining
poration is treated as becoming or ceasing year is the sum of its § 199 deductions for W–2 wages a taxpayer may take into ac-
to be a member of the EAG at the end of each portion of the taxable year. count any wages paid by another entity and
the day on which its status as a member (8) Computation of § 199 deduction for reported by the other entity on Forms W–2
changes. members of Expanded Affiliated Group with the other entity as the employer listed
(6) Allocation of income and loss. A with different taxable years. If members in Box c of the Forms W–2, provided that
corporation that is a member of an EAG of an EAG have different taxable years, the wages were paid to employees of the
for only a portion of its taxable year must in computing the § 199 deduction of a taxpayer for employment by the taxpayer.
allocate its taxable income or loss, QPAI, member (the “computing member”), with If the taxpayer is treated as an employer
and W–2 wages between the portion of the respect to each member of the EAG, the described in § 3401(d)(1) because of con-
taxable year during which it is a member computing member is required to take trol of the payment of wages (that is, the
of the EAG and the portion of the tax- into account the taxable income or loss, taxpayer is not the common law employer
able year during which it is not a mem- QPAI, and W–2 wages that are both (1) of the payee of the wages), the payment of
ber of the EAG. In general, this allocation attributable to the period during which the wages may not be included in determining
of items must be made by using the pro member of the EAG and the computing W–2 wages of the taxpayer. If the taxpayer
rata allocation method described in sec- member are both members of the EAG, is paying wages as an agent of another en-
tion 4.09(6)(a)(i) of this notice. However, and (2) taken into account in a taxable year tity to individuals who are not employees
the corporation may elect to use the clos- that begins after the effective date of § 199 of the taxpayer, the wages may not be in-
ing of the books method described in sec- and ends with or within the taxable year cluded in determining the W–2 wages of
tion 4.09(6)(a)(ii). Section 4.09(6)(a)(iii) of the computing member with respect to the taxpayer.
prescribes rules for the time and manner which the § 199 deduction is computed. (b) No application in determining
of making the election to use the closing whether amounts are wages for employ-
of the books method. SECTION 4. INTERIM GUIDANCE ment tax purposes. The discussion of
(a) Pro rata allocation method. Under “wages” in this notice is for purposes of
the pro rata allocation method, an equal .01 In General. Under § 199(a)(1), a § 199 only and has no application in deter-
portion of each of the taxable income or taxpayer may deduct an amount equal to mining whether amounts are wages under
loss, QPAI, and W–2 wages for the taxable 9 percent (3 percent in the case of tax- § 3121(a) for purposes of the FICA, under
year is assigned to each day of the corpora- able years beginning in 2005 and 2006, § 3306(b) for purposes of the FUTA, under
tion’s taxable year. Then, those items as- and 6 percent in the case of taxable years § 3401(a) for purposes of the Collection
signed to those days during which the cor- beginning in 2007, 2008, or 2009) of the of Income Tax at Source on Wages (fed-
poration was a member of the EAG are ag- lesser of the taxpayer’s QPAI (as defined eral income tax withholding), or any other
gregated. in section 4.03 of this notice) for the tax- wage related determination.
(b) Closing of the books method. Under able year, or the taxpayer’s taxable income (c) Application in case of taxpayer with
the closing of the books method, taxable (determined without regard to § 199) for short taxable year. In the case of a tax-
income or loss, QPAI, and W–2 wages for the taxable year. For purposes of the pre- payer with a short taxable year, subject to
the period during which the corporation ceding sentence, the definition of taxable the rules of section 4.02(1)(a) of this no-
was a member of the EAG are computed income under § 63 shall apply. tice, the W–2 wages of the taxpayer for
by treating the corporation’s taxable year .02 Wage Limitation. (1) Rules of ap- the short taxable year shall include those
as two separate taxable years, the first of plication. (a) In general. Pursuant to wages paid during the short taxable year to
which ends at the close of the day on which § 199(b)(1), the amount of the deduction employees of the taxpayer as determined
the corporation’s status as a member of allowable to the taxpayer under § 199(a) under the tracking wages method. Under
the EAG changes and the second of which for any taxable year shall not exceed 50 the tracking wages method described in
begins at the beginning of the day after percent of the W–2 wages of the taxpayer. section 4.02(2)(b)(iii), the taxpayer must
the corporation’s status as a member of the For this purpose, except as provided in sec- calculate W–2 wages by tracking wages
EAG changes. tion 4.02(1)(c) of this notice, the Forms actually paid during the short taxable year
(7) Total § 199 deduction for a corpo- W–2 used in determining the amount of to employees, subject to the modifications
ration that is a member of an expanded af- W–2 wages are those issued for the cal- that in step (B) only the supplemental un-

2005–7 I.R.B. 514 February 14, 2005


employment compensation benefits paid (b) Methods for calculating W–2 wages. § 3402(o)(2)(A)) that were included in
during the short taxable year are required Taxpayers may use one of three methods the total in Step A; and
to be deducted and that in step (C) of such in calculating W–2 wages. These three (C) Add to the amount obtained after
method only the portions of the amounts methods are subject to the non-duplica- Step (B) amounts that are reported in Box
reported in Box 12, Codes D, E, F, G, and tion rule provided in section 4.02(1)(e) of 12 of Forms W–2 with respect to employ-
S actually deferred or contributed during this notice, and the tracking wages method ees of the taxpayer for employment by the
the short taxable year may be included in is subject to the rule provided in section taxpayer and that are properly coded D, E,
the W–2 wages. 4.02(1)(c), if applicable. F, G or S.
(d) Acquisition or disposition of a trade (i) Unmodified box method. Under this .03 Determining Qualified Produc-
or business (or major portion). If a tax- method, W–2 wages are calculated by tak- tion Activities Income. (1) In general.
payer (a successor) acquires the major por- ing, without modification, the lesser of: Section 199(c)(1) defines QPAI for any
tion of a trade or business or the major por- (A) The total entries in Box 1 of all taxable year as an amount equal to the ex-
tion of a separate unit of a trade or business Forms W–2 filed with the SSA by the tax- cess (if any) of (A) the taxpayer’s DPGR
from another taxpayer (a predecessor), the payer with respect to employees of the tax- (as defined in section 4.04 of this notice),
W–2 wages of each of the successor and payer for employment by the taxpayer; or over (B) the sum of (i) the CGS that are
predecessor for purposes of computing the (B) The total entries in Box 5 of all allocable to such receipts (see section
§ 199 deduction shall be computed pur- Forms W–2 filed with the SSA by the tax- 4.05), (ii) other deductions, expenses, or
suant to the rules of this notice, including payer with respect to employees of the tax- losses directly allocable to such receipts
sections 4.02(1) and 4.02(2) of this notice, payer for employment by the taxpayer. (see section 4.05), and (iii) a ratable por-
regardless of whether the W–2 wages are (ii) Modified Box 1 method. Under this tion of other deductions, expenses, and
reported on Forms W–2 furnished by the method, the taxpayer makes modifications losses that are not directly allocable to
successor or Forms W–2 furnished by the to the total entries in Box 1 of Forms W–2 such receipts or another class of income
predecessor. filed with respect to employees of the tax- (see section 4.05). For purposes of § 199,
(e) Non-duplication rule. Amounts that payer. W–2 wages under this method are QPAI is determined on an item-by-item
are treated as W–2 wages for a taxable year calculated as follows: basis (and not, for example, on a divi-
under any method may not be treated as (A) Total the amounts in Box 1 of sion-by-division, product line-by-product
W–2 wages of any other taxable year. Forms W–2 with respect to employees line, or transaction-by-transaction basis)
(2) Definition of “W–2 wages.” (a) In of the taxpayer for employment by the and is the sum of QPAI derived by the
general. Section 199(b)(2) defines W–2 taxpayer; taxpayer from each item. For purposes of
wages for purposes of § 199(b)(1) as the (B) Subtract from the total in Step (A) this determination, QPAI from each item
sum of the amounts required to be included amounts included in Box 1 of Forms W–2 may be positive or negative. For example,
on statements under § 6051(a)(3) and (8) that are not wages for federal income tax if a taxpayer manufactures a shirt and a hat
with respect to employment of employees withholding purposes and amounts in- in the United States, and the QPAI derived
of the taxpayer for the calendar year. Thus, cluded in Box 1 of Forms W–2 that are from the manufacture of the shirt is $3 and
the term W–2 wages includes: (i) the total treated as wages under § 3402(o) (for the QPAI derived from the manufacture of
amount of wages as defined in § 3401(a); example, supplemental unemployment the hat is ($1), the taxpayer’s QPAI is $2.
(ii) the total amount of elective deferrals compensation benefits); and (2) Allocation of gross receipts. A tax-
(within the meaning of § 402(g)(3)); (iii) (C) Add to the amount obtained after payer must determine the portion of its
the compensation deferred under § 457; Step (B) amounts that are reported in Box gross receipts that are DPGR and the por-
and (iv) for tax years beginning after De- 12 of Forms W–2 with respect to employ- tion of its gross receipts that are not DPGR.
cember 31, 2005, the amount of designated ees of the taxpayer for employment by the For example, if a taxpayer leases, rents, li-
Roth contributions (as defined in § 402A). taxpayer and that are properly coded D, E, censes, sells, exchanges, or otherwise dis-
Under the 2004 and 2005 Form W–2, the F, G, or S. poses of QPP, the gross receipts of which
elective deferrals under § 402(g)(3) and (iii) Tracking wages method. Under this constitute DPGR, and engages in trans-
the amounts deferred under § 457 directly method, the taxpayer actually tracks total actions with respect to similar property,
correlate to coded items reported in Box wages subject to federal income tax with- the gross receipts of which do not con-
12 on Form W–2. Box 12, Code D is for holding and makes appropriate modifica- stitute DPGR, the taxpayer must allocate
elective deferrals to a § 401(k) cash or de- tions. W–2 wages under this method are its gross receipts from all the transactions
ferred arrangement; Box 12, Code E is for calculated as follows: based on a reasonable method that is sat-
elective deferrals under a § 403(b) salary (A) Total the amounts of wages sub- isfactory to the Secretary and that accu-
reduction agreement; Box 12, Code F is ject to federal income tax withholding that rately identifies the gross receipts that con-
for elective deferrals under a § 408(k)(6) are paid to employees of the taxpayer for stitute DPGR. Factors taken into consider-
salary reduction Simplified Employee employment by the taxpayer and that are ation in determining whether the method
Pension (SEP); Box 12, Code G is for reported on Forms W–2 for the calendar is reasonable include whether the taxpayer
elective deferrals under a § 457(b) plan; year; uses the most accurate information avail-
and Box 12, Code S is for employee salary (B) Subtract from the total in Step able; the relationship between the gross
reduction contributions under a § 408(p) (A) the supplemental unemployment receipts and the apportionment base cho-
SIMPLE (simple retirement account). compensation benefits (as defined in sen; the accuracy of the method chosen

February 14, 2005 515 2005–7 I.R.B.


as compared with other possible methods; ing CGS and expenses) qualify as DPGR. receipts do not include the repayment of
whether the method is used by the taxpayer See section 4.03(2) of this notice for the a loan or similar instrument (for example,
for internal management or other business factors taken into consideration in deter- a repayment of the principal amount of a
purposes; whether the method is used for mining whether the taxpayer’s method is loan held by a commercial lender) and,
other federal, state, or foreign income tax reasonable. except to the extent of gain recognized,
purposes; the time, burden, and cost of .04 Determining Domestic Produc- do not include gross receipts derived from
using various methods; and whether the tion Gross Receipts. (1) In general. a non-recognition transaction such as a
taxpayer applies the method consistently Section 199(c)(4)(A) defines DPGR as § 1031 exchange. Finally, gross receipts
from year to year. All of a taxpayer’s the gross receipts (as defined in section do not include amounts received by the
gross receipts are treated as DPGR if less 4.04(2) of this notice) of the taxpayer that taxpayer with respect to sales tax or other
than 5 percent of the taxpayer’s total gross are derived from (as defined in section similar state and local taxes if, under the
receipts are non-DPGR (after application 4.04(7)): applicable state or local law, the tax is
of other de minimis safe harbors provided (a) Any lease, rental, license, sale, ex- legally imposed on the purchaser of the
in section 4 of this notice that result in change, or other disposition of: good or service, and the taxpayer merely
gross receipts being treated as DPGR). If (i) QPP (as defined in section 4.04(8)) collects and remits the tax to the taxing au-
the amount of the taxpayer’s gross receipts that is MPGE (as defined in section thority. If, in contrast, the tax is imposed
that do not qualify as DPGR equals or ex- 4.04(3)) by the taxpayer (as defined in on the taxpayer under the applicable law,
ceeds 5 percent of the total gross receipts, section 4.04(4)) in whole or in significant then gross receipts include the amounts
the taxpayer is required to allocate all gross part (as defined in section 4.04(5)) within received that are allocable to the payment
receipts between DPGR and non-DPGR. the United States (as defined in section of of such tax.
For example, if a taxpayer only derives 4.04(6)), (3) Definition of “manufactured, pro-
gross receipts from the sale of gasoline re- (ii) Any qualified film (as defined in duced, grown, or extracted.” (a) In gen-
fined by the taxpayer in the United States section 4.04(9)) produced by the taxpayer eral. The terms MPGE in § 199(c)
and the sale of gasoline the taxpayer ac- (in accordance with section 4.04(9)), or (4)(A)(i)(I) include activities relating
quired (either by purchase or in exchange (iii) Electricity, natural gas, or potable to manufacturing, producing, growing,
for gasoline refined by the taxpayer in the water (as defined in section 4.04(10)) pro- extracting, installing, developing, improv-
United States) from an unrelated party, the duced by the taxpayer in the United States ing, and creating QPP; making QPP out of
taxpayer must allocate its gross receipts (in accordance with section 4.04(10)), scrap, salvage, or junk material as well as
between the gross receipts attributable to (b) Construction (as defined in section from new or raw material by processing,
the gasoline refined by the taxpayer in the 4.04(11)) performed in the United States manipulating, refining, or changing the
United States (that qualify as DPGR as- (in accordance with section 4.04(11)), or form of an article, or by combining or as-
suming all other requirements of § 199 (c) Engineering or architectural ser- sembling two or more articles; cultivating
are met) and the taxpayer’s gross receipts vices (as defined in section 4.04(12)) soil, raising livestock, fishing, and mining
derived from the resale of the acquired performed in the United States for con- minerals. The terms also include storage,
gasoline (that do not qualify as DPGR) if struction projects in the United States (in handling or other processing activities
5 percent or more of the taxpayer’s total accordance with 4.04(12)). (other than transportation activities) within
gross receipts are not from the sale of gaso- (2) Definition of “gross receipts.” The the United States related to the sale, ex-
line refined by the taxpayer in the United term “gross receipts” means the taxpayer’s change or other disposition of agricultural
States. Similarly, a taxpayer that manu- receipts for the taxable year that are rec- products, provided the products are con-
factures the same type of QPP at facili- ognized under the taxpayer’s method of sumed in connection with, or incorporated
ties within the United States and outside accounting used in that taxable year for into, the MPGE of QPP whether or not by
the United States must allocate its gross re- federal income tax purposes. For this the taxpayer. For example, assume A, B,
ceipts between the receipts from the QPP purpose, gross receipts include total sales and C are unrelated taxpayers. A owns
manufactured in the United States and re- (net of returns and allowances) and all grain storage bins in the United States in
ceipts from the QPP not manufactured in amounts received for services. In addi- which it stores for a fee B’s corn that was
the United States if 5 percent or more of tion, gross receipts include any income grown in the United States. B sells its corn
its total gross receipts are non-DPGR. from investments, and from incidental or to C. C processes B’s corn into corn syrup
(3) Treatment of advance payments. If outside sources. For example, gross re- in the United States. The gross receipts
a taxpayer recognizes an advance payment ceipts include interest (including original from A’s, B’s, and C’s activities are DPGR
for goods, services, use of property, etc., issue discount and tax-exempt interest from the MPGE of QPP.
in gross receipts in a taxable year ear- within the meaning of § 103), dividends, (b) Consistency with § 263A. A tax-
lier than the taxable year the goods, ser- rents, royalties, and annuities, regard- payer that has MPGE QPP for the taxable
vices, use of property, etc., to which the ad- less of whether the amounts are derived year should treat itself as a producer un-
vance payment relates are delivered, per- in the ordinary course of the taxpayer’s der § 263A with respect to the QPP for
formed, provided, etc., the taxpayer must trade of business. Gross receipts are not the taxable year unless the taxpayer is not
accurately identify based on a reasonable reduced by CGS or by the cost of prop- subject to § 263A under the Code, regu-
method that is satisfactory to the Secre- erty sold if such property is described in lations, or other published guidance. A
tary whether the receipts (and correspond- § 1221(a)(1), (2), (3), (4) or (5). Gross taxpayer that currently is not properly ac-

2005–7 I.R.B. 516 February 14, 2005


counting for its production activities under QPP under § 199, then the taxpayer must nor assembly operations do not qualify as
§ 263A, and wishes to change its method determine whether the MPGE performed conversion costs.
of accounting to comply with the producer by the other party on behalf of the taxpayer (6) Definition of “United States.” For
requirements of § 263A, must follow the is performed in whole or in significant part purposes of § 199, the term “United States”
procedures of Rev. Proc. 97–27 or Rev. within the United States. includes the 50 states, the District of Co-
Proc. 2002–9, whichever applies. (b) Substantial in nature. QPP will lumbia, the territorial waters of the United
(4) Definition of “by the taxpayer.” be treated as MPGE in significant part by States, and the seabed and subsoil of those
With the exception of the rules provided in the taxpayer within the United States if submarine areas that are adjacent to the
section 4.09(2)(b) of this notice applicable the MPGE of the QPP performed by the territorial waters of the United States and
to an EAG, if one taxpayer performs a taxpayer within the United States is sub- over which the United States has exclu-
qualifying activity under § 199(c)(4)(A)(i) stantial in nature taking into account all sive rights, in accordance with interna-
pursuant to a contract with another party, the facts and circumstances, including the tional law, with respect to the exploration
then only the taxpayer that has the benefits relative value added by, and relative cost and exploitation of natural resources. The
and burdens of ownership of the property of, the taxpayer’s MPGE activity in the term “United States” does not include pos-
under federal income tax principles during United States, the nature of the property, sessions and territories of the United States
the period the qualifying activity occurs and the nature of the MPGE activity that or the airspace over the United States and
is treated as engaging in the qualifying the taxpayer performs in the United States. these areas.
activity. For example, if property is MPGE by the (7) Definition of “derived from the
(5) Definition of “in whole or in signif- taxpayer outside the United States or by lease, rental, license, sale, exchange, or
icant part.” (a) In general. QPP described an unrelated party within the United States other disposition of qualifying production
in § 199(c)(4)(A)(i)(I) must be MPGE in and the property is used as a component property.” (a) In general. The term “de-
whole or in significant part by the tax- part of the QPP produced by the taxpayer rived from the lease, rental, license, sale,
payer within the United States. Except in within the United States, the QPP (includ- exchange, or other disposition of qualify-
the case of a related person transaction un- ing the component part) will be treated ing production property” is defined as, and
der § 199(c)(7), DPGR includes all of the as MPGE in significant part by the tax- limited to, the gross receipts directly from
taxpayer’s gross receipts derived from the payer within the United States if the pro- the lease, rental, license, sale, exchange,
lease, rental, license, sale, exchange, or duction of the QPP performed by the tax- or other disposition of QPP. For example,
other disposition of QPP for which the tax- payer within the United States is substan- “derived from the sale of QPP” includes
payer MPGE the QPP in whole or in sig- tial in nature. In addition, if a taxpayer gross receipts from the sale of QPP manu-
nificant part in the United States. For ex- purchases unrefined oil extracted outside factured in whole or in significant part in
ample, if a taxpayer imports QPP that is the United States by an unrelated party and the United States by a taxpayer for sale,
partially manufactured, the taxpayer com- the taxpayer refines the oil in the United as well as gross receipts from the sale
pletes the manufacture of the QPP in the States, the refining of the oil by the tax- of self-constructed QPP manufactured in
United States, and the taxpayer’s comple- payer in the United States will be treated as whole or in significant part in the United
tion of the manufacturing of the QPP in MPGE that is substantial in nature within States by a taxpayer and used in the tax-
the United States satisfies the “in signifi- the United States. However, packaging, payer’s trade or business before being
cant part” requirement, then the taxpayer’s repackaging, labeling, and minor assembly sold. In addition, the proceeds from busi-
gross receipts from the sale of the QPP operations do not qualify as substantial in ness interruption insurance and payments
qualify as DPGR (assuming all other re- nature. In addition, development activities not to produce are treated as gross receipts
quirements of § 199(c) are met). In ad- and the creation or licensing of intangibles “derived from the lease, rental, license,
dition, if a taxpayer manufactures QPP in do not qualify as substantial in nature for sale, exchange, or other disposition of
significant part in the United States and ex- any QPP other than computer software and QPP” to the extent that they are substitutes
ports the QPP for further manufacture out- sound recordings. for gross receipts that would qualify as
side the United States, the taxpayer’s gross (c) Safe harbor. A taxpayer will be DPGR. The value of property received
receipts derived from the lease, rental, li- treated as having MPGE property in whole in an exchange of QPP that was MPGE
cense, sale, exchange, or other disposition or in significant part within the United by the taxpayer for QPP that was MPGE
of that QPP will be considered DPGR, re- States if, in connection with the property, by an unrelated taxpayer is DPGR for the
gardless of whether the QPP is imported conversion costs (direct labor and related taxpayer. The value of property acquired
back into the United States prior to the factory burden) to MPGE the property are by a taxpayer in exchange for QPP is gross
lease, rental, license, sale, exchange, or incurred by the taxpayer within the United receipts derived from an exchange of the
other disposition of the QPP (assuming all States and the costs account for 20 percent QPP, and is DPGR if the QPP was MPGE
other requirements of § 199(c) are met). If or more of the total CGS of the property. by the taxpayer in whole or in significant
a taxpayer enters into a contract with an- For purposes of this safe harbor, devel- part within the United States. However,
other party and the taxpayer has the bene- opment costs and the cost of any intangi- any gross receipts from the subsequent
fits and burdens of ownership of the QPP bles do not qualify as conversion costs for sale by the taxpayer of the property that
under federal income tax principles during any QPP other than computer software and the taxpayer acquired in the exchange are
the period the MPGE activity occurs and sound recordings. In addition, the costs of not DPGR, because the taxpayer did not
the taxpayer is considered to MPGE the packaging, repackaging, labeling, and mi- MPGE the property acquired in the ex-

February 14, 2005 517 2005–7 I.R.B.


change, even if that property is QPP that (d) Computer software. Gross receipts purposes of § 199(c)(5)(A) even though
had been MPGE within the United States derived from computer software (as de- under local law the property is considered
by the other party to the exchange. fined in section 4.04(8)(c)) do not include a fixture and therefore real property. Thus,
(b) Allocation of gross receipts — em- gross receipts derived from Internet ac- property such as production machinery,
bedded services. Except with respect to cess services, online services, customer printing presses, transportation and office
construction or engineering or architec- support, telephone services, games played equipment, refrigerators, grocery coun-
tural services described in § 199(c)(4)(ii) through a website, provider-controlled ters, testing equipment, display racks and
and (iii), gross receipts “derived from” the software online access services, and other shelves, and neon and other signs that is
performance of services do not qualify as services that do not constitute the lease, contained in or attached to a building con-
DPGR. In the case of an embedded service, rental, license, sale, exchange, or other stitutes tangible personal property for pur-
that is, a service the price of which is in- disposition of computer software that was poses of § 199(c)(5)(A). Further, property
cluded in the amount charged for the lease, developed by the taxpayer. that is in the nature of machinery (other
rental, license, sale, exchange, or other dis- (e) Exception for certain oil and gas than structural components of a building)
position of property, DPGR includes only partnerships. If a partnership is engaged is tangible personal property even though
the receipts from the lease, rental, license, solely in the extraction, refining, process- located outside a building. Thus, for ex-
sale, exchange, or other disposition of the ing, etc., of oil or gas and distributes the ample, a gasoline pump, hydraulic car lift,
property and not any receipts attributable oil or gas or products derived from the oil or automatic vending machine, although
to the embedded service (assuming all or gas (products) to its partners who then annexed to the ground, is considered tan-
other requirements of § 199(c) are met). sell the oil or gas or products, then, for pur- gible personal property. A structure that
There are two exceptions to this general poses of § 199, the gross receipts derived is property in the nature of machinery
rule regarding embedded services. First, a by the partners from the sale of the oil or or is essentially an item of machinery or
taxpayer may include in DPGR (assuming gas or products are treated as gross receipts equipment is not an inherently permanent
all other requirements of § 199(c) are met) derived by the partnership from the MPGE structure and is tangible personal property.
gross receipts from a qualified warranty of QPP. The partnership must follow the In the case, however, of a building or in-
(that is, a warranty that is provided in con- rules provided in section 4.06 of this no- herently permanent structure that includes
nection with the sale of QPP if (1) in the tice regarding the application of § 199 to property in the nature of machinery as a
normal course of its business, the charge pass-thru entities to ensure that the costs structural component, the property in the
for the warranty is included in the price attributable to oil or gas or products are nature of machinery is real property. The
charged for the lease, rental, license, sale, properly taken into account. term “tangible personal property” does
exchange, or other disposition of the QPP (8) Definition of “qualifying produc- not include the creation of copyrighted
and (2) the warranty is neither separately tion property.” (a) In general. Qualifying material such as a manuscript in a form
offered by the taxpayer nor separately bar- production property includes: (1) tan- other than in a tangible medium.
gained for with the customer (that is, the gible personal property, as defined in (c) Computer software. The term “com-
customer cannot purchase the QPP with- section 4.04(8)(b); (2) computer software, puter software” means any program or rou-
out the warranty)). Second, a de minimis as defined in section 4.04(8)(c); and (3) tine or any sequence of machine-readable
amount of gross receipts from embedded sound recordings, as defined in section code that is designed to cause a computer
services for each item of property may 4.04(8)(d). to perform a desired function or set of
qualify as DPGR. A de minimis amount (b) Tangible personal property. The functions, and the documentation required
of gross receipts from embedded services term “tangible personal property” is to describe and maintain that program or
is less than 5 percent of the gross receipts any tangible property other than land, routine. Computer software also includes
derived from the lease, rental, license, buildings, (including items that are the machine-readable coding for video
sale, exchange, or other disposition of the structural components of such build- games and similar programs, regardless
property. For purposes of applying this de ings) and any property described un- of whether the program is designed to
minimis test, gross receipts from qualified der § 199(c)(4)(A)(i)(II) and (III), or operate on a “computer” (as defined in
warranties are not treated as gross receipts § 199(c)(5)(B) and (C). Thus, qualified § 168(i)(2)(B)). If the medium in which
for services. films, computer software, and sound the software is contained, whether writ-
(c) Advertising income. Gross receipts recordings are not tangible personal prop- ten, magnetic, or otherwise, is tangible,
that are “derived from” the sale or other erty regardless of whether they are fixed then such medium is considered tangible
disposition of newspapers and magazines on a tangible medium. However, the tangi- personal property for purposes of § 199.
include advertising income. For example, ble medium on which the property is fixed Therefore, if a taxpayer develops a soft-
a newspaper manufacturer’s gross receipts (for example, a videocassette, a computer ware program that it reproduces and sells
from an advertiser to publish display ad- diskette, or other similar tangible item) is on diskettes, the program fixed on the
vertising or classified advertisements in its tangible personal property. In determin- diskette is treated as computer software,
newspaper are treated as gross receipts de- ing whether property is “tangible personal and the diskette is treated as tangible per-
rived from the sale of the newspapers (as- property,” the fact that property is personal sonal property. Computer programs of all
suming all other requirements of § 199 are property or tangible property under local classes, for example, operating systems,
met). law is not controlling. Conversely, prop- executive systems, monitors, compilers
erty may be tangible personal property for and translators, assembly routines, and

2005–7 I.R.B. 518 February 14, 2005


utility programs as well as application not less than 50 percent of the total com- Title 18 requires maintenance of certain
programs, are included. Computer soft- pensation relating to the production of the records with respect to any book, maga-
ware also includes any incidental and property is compensation for services per- zine, periodical, film, videotape, or other
ancillary rights that are necessary to effect formed in the United States by actors, pro- matter that (1) contains one or more visual
the acquisition of the title to, the owner- duction personnel, directors, and produc- depictions made after November 1, 1990,
ship of, or the right to use the computer ers. The term “production personnel” in- of actual sexually explicit conduct and (2)
software, and that are used only in connec- cludes writers, choreographers and com- is produced in whole or in part with materi-
tion with that specific computer software. posers providing services during the pro- als that have been mailed or shipped in in-
Such incidental and ancillary rights are duction of a film, casting agents, camera terstate or foreign commerce, or is shipped
not included in the definition of trademark operators, set designers, lighting techni- or transported or is intended for shipment
or trade name under § 1.197–2(b)(10)(i). cians, make-up artists, and others whose or transportation in interstate or foreign
For example, a trademark or trade name activities are directly related to the produc- commerce.
that is ancillary to the ownership or use tion of the film. “Production personnel” do (10) Electricity, natural gas, and
of a specific computer software program not include, however, individuals whose potable water. (a) In general. DPGR
in the taxpayer’s trade or business and is activities are ancillary to the production, includes gross receipts derived from any
not acquired for the purpose of marketing such as advertisers and promoters, distrib- lease, rental, license, sale, exchange, or
the computer software is included in the utors, studio administrators and managers, other disposition of electricity, natural gas,
definition of computer software and is not studio security personnel, and personal as- or potable water produced by the taxpayer
included in the definition of trademark sistants to actors. If the medium on which in the United States (assuming all other
or trade name. Computer software does a qualified film is fixed is tangible (such as requirements of § 199(c) are met). DPGR
not include any data or information base a DVD), such medium is treated as tangi- does not include gross receipts of the tax-
unless the data base or item is in the public ble personal property. Therefore, a DVD payer derived from the transmission or
domain and is incidental to a computer copy of a motion picture consists of both distribution of these items.
program. For this purpose, a copyrighted a qualified film (the motion picture con- (b) Natural gas. The term “natural
or proprietary data or information base is tent embodied in the disc) and tangible per- gas” includes only natural gas extracted
treated as in the public domain if its avail- sonal property (the disc itself). from a natural deposit and does not in-
ability through the computer program does (b) Compensation for services. The clude, for example, methane gas extracted
not contribute significantly to the cost of term “compensation for services” means from a landfill. In the case of natural gas,
the program. For example, if a word-pro- all payments for services performed by production activities include all activities
cessing program includes a dictionary actors, production personnel, directors, involved in extracting natural gas from
feature that may be used to spell-check and producers, including participations the ground and processing the gas into
a document or any portion thereof, the and residuals. In the case of a taxpayer pipeline quality gas.
entire program (including the dictionary that uses the income forecast method of (c) Potable water. The term “potable
feature) is computer software regardless § 167(g) and capitalizes participations water” means unbottled drinking water. In
of the form in which the dictionary feature and residuals into the adjusted basis of the case of potable water, production ac-
is maintained or stored. the qualified film, the taxpayer must use tivities include the acquisition, collection,
(d) Sound recordings. The term “sound the same estimate of participations and and storage of raw water (untreated water),
recordings” means any works that result residuals for purposes of § 199 that it uses transportation of raw water to a water treat-
from the fixation of a series of musical, for purposes of § 167(g). In the case of ment facility, and treatment of raw water at
spoken, or other sounds. If the medium a taxpayer that excludes participations such a facility. Gross receipts attributable
(such as compact discs, tapes, or other and residuals from adjusted basis of the to any of these activities are included in
phonorecordings) in which the sounds are qualified film under § 167(g)(7)(D)(i), the DPGR (assuming all other requirements of
embodied is tangible, the medium is con- taxpayer must determine the compensa- § 199(c) are met). DPGR does not include,
sidered tangible personal property for pur- tion expected to be paid as participations however, gross receipts derived from the
poses of § 199. Therefore, the sale of and residuals based on the total forecasted storage of potable water after completion
an audio cassette involves both a sound income used in determining income fore- of treatment of the potable water, or deliv-
recording (the sounds fixed on the tape) cast depreciation. ery of potable water to customers.
and tangible personal property (the cas- (c) Determination of 50 percent. A tax- (d) Exceptions. In the case of an
sette itself). See section 4.04(8)(c) of this payer may use any reasonable method of integrated producer that both produces
notice. The term “sound recordings” does making the allocation. Among the factors and delivers electricity, natural gas, or
not include the creation of copyrighted ma- to be considered in determining whether a potable water, the taxpayer must allo-
terial in a form other than a sound record- taxpayer’s method of allocating compen- cate its gross receipts between production
ing, such as lyrics or music written on pa- sation is reasonable is whether the tax- (DPGR) and distribution and transmis-
per or other similar material. payer uses that method consistently. sion (non-DPGR). However, if less than
(9) Definition of “qualified film.” (a) In (d) Exception. A “qualified film” does 5 percent of a taxpayer’s gross receipts
general. The term “qualified film” means not include property with respect to which derived from a sale of electricity, natural
any motion picture film, video tape, or records are required to be maintained un- gas, or potable water are attributable to the
live or delayed television programming if der 18 U.S.C. § 2257. Section 2257 of transmission or distribution of the elec-

February 14, 2005 519 2005–7 I.R.B.


tricity, natural gas, or potable water, then ing whether property is “real property,” the from the sale, exchange, or other dispo-
the gross receipts derived from that sale fact that property is real property under sition of real property constructed by the
that are attributable to the transmission local law is not controlling. Conversely, taxpayer in the United States (whether
and distribution of the electricity, natural property may be real property for purposes or not the property is sold immediately
gas, or potable water will be treated for of § 199(c)(4)(A)(ii) even though under lo- after construction is completed). DPGR
purposes of § 199 as being DPGR (assum- cal law the property is considered tangible derived from the construction of real prop-
ing all other requirements of § 199(c) are personal property. erty also includes compensation for the
met). (b) Activities constituting construction. performance of construction services by
(i) Electricity. Gross receipts attribut- Activities constituting construction in- the taxpayer in the United States. How-
able to the transmission of electricity from clude activities performed in connection ever, DPGR derived from the construction
the generating facility to a point of local with a project to erect or substantially of real property does not include gross
distribution and gross receipts attributable renovate real property, but do not include receipts from the lease or rental of real
to the distribution of electricity to final tangential services such as hauling trash property constructed by the taxpayer or
customers are not DPGR. and debris, and delivering materials, even gross receipts attributable to the sale or
(ii) Natural gas. Gross receipts attribut- if the tangential services are essential other disposition of land.
able to the transmission of pipeline quality for construction. However, if the tax- (12) Definition of “Engineering and
gas from a natural gas field (or from a natu- payer performing construction also, in architectural services.” (a) In general.
ral gas processing plant) to a local distribu- connection with the construction project, DPGR includes gross receipts derived
tion company’s citygate (or to another cus- provides tangential services such as de- from engineering or architectural services
tomer) are not DPGR. Likewise, gross re- livering materials to the construction site performed in the United States for con-
ceipts of a local gas distribution company and removing its construction debris, the struction projects in the United States (as-
attributable to distribution from the city- gross receipts derived from the tangen- suming all other requirements of § 199(c)
gate to the local customers are not DPGR. tial services are DPGR. Improving land are met). The engineering or architectural
(iii) Potable water. Gross receipts at- (for example, grading and landscaping) services must relate to real property, must
tributable to the storage of potable wa- and painting are activities constituting be performed in the United States, and the
ter after completion of treatment of the construction only if these activities are taxpayer providing these services must
potable water, as well as gross receipts at- performed in connection with other activi- be able to substantiate that the services
tributable to the transmission and distribu- ties (whether or not by the same taxpayer) relate to a construction project within
tion of potable water, are not DPGR. that constitute the erection or substantial the United States. DPGR includes gross
(11) Definition of “construction per- renovation of real property. The taxpayer receipts derived from engineering or ar-
formed in the United States.” (a) Construc- engaged in these activities must make a chitectural services even if the planned
tion of real property. The term “construc- reasonable inquiry to determine whether construction project is not undertaken or
tion” means the construction or erection of the activity relates to the erection or sub- is not completed (subject to the taxpayer
real property (that is, residential and com- stantial renovation of real property. The substantiating that the services relate to
mercial buildings (including items that are term “construction” does not include any a construction project that would have
structural components of such buildings), activity that is within the definition of been within the United States if it had
inherently permanent structures other than “engineering and architectural services” been undertaken and assuming all other
tangible personal property in the nature (see section 4.04(12) of this notice). requirements of § 199(c) are met).
of machinery (see section 4.04(8)(b) of (c) Definition of “infrastructure.” The (b) Engineering services. Engineering
this notice), inherently permanent land im- term “infrastructure” includes roads, services in connection with any con-
provements, and infrastructure) by a tax- power lines, water systems, railroad spurs, struction project include any professional
payer that is in a trade or business that communications facilities, sewers, side- services requiring engineering educa-
is considered construction for purposes of walks, cable, and wiring. The term also tion, training, and experience and the
the North American Industry Classifica- includes inherently permanent oil and gas application of special knowledge of the
tion System (NAICS codes). Tangible per- platforms. mathematical, physical, or engineering
sonal property (as defined under section (d) Definition of “substantial renova- sciences to those professional services
4.04(8)(b)) (for example, appliances, fur- tion.” The term “substantial renovation” such as consultation, investigation, eval-
niture and fixtures) that is sold as part means the renovation of a major compo- uation, planning, design, or responsible
of a construction project is not consid- nent or substantial structural part of real supervision of construction for the pur-
ered real property for this purpose. How- property that materially increases the value pose of assuring compliance with plans,
ever, if more than 95 percent of the total of the property, substantially prolongs the specifications, and design.
gross receipts derived by a taxpayer from useful life of the property, or adapts the (c) Architectural services. Architec-
a construction project are derived from real property to a new or different use. tural services in connection with any
property (as defined in § 1.263A–8(c)), (e) “Derived from construction.” As- construction project include the offering
then the total gross receipts derived by the suming all other requirements of § 199(c) or furnishing of any professional services
taxpayer from the project are DPGR from are met, DPGR derived from the con- such as consultation, planning, aesthetic
construction (assuming all other require- struction of real property performed in and structural design, drawings and spec-
ments of § 199(c) are met). In determin- the United States includes the proceeds ifications, or responsible supervision of

2005–7 I.R.B. 520 February 14, 2005


construction (for the purpose of assuring by the amount of CGS directly allocable justed basis of noninventory property, the
compliance with plans, specifications, and to DPGR, the amount of deductions di- gross receipts from the sale or other dispo-
design) or erection, in connection with any rectly allocable to DPGR and a ratable por- sition of which are included in DPGR.
construction project. tion of other deductions not directly al- (b) Allocating cost of goods sold. If a
(d) De minimis exception for perfor- locable to DPGR, or another class of in- taxpayer can identify from its books and
mance of services in the United States. come. Section 4.05(2) of this notice pro- records CGS allocable to DPGR, CGS
If gross receipts derived from engineer- vides rules for determining CGS directly allocable to DPGR is that amount. How-
ing or architectural services (1) performed allocable to DPGR. Section 4.05(3) pro- ever, if a taxpayer’s books and records
outside the United States or (2) related vides rules for determining the deductions do not allow the taxpayer to identify
to property other than real property for allocated and apportioned to DPGR and a CGS allocable to DPGR, the taxpayer
a construction project inside the United ratable portion of deductions not directly must use a reasonable method to allocate
States total less than 5 percent of the total allocable to DPGR or another class of in- CGS between DPGR and other gross re-
gross receipts of the taxpayer derived from come. Section 4.05(3) generally provides ceipts. If a taxpayer uses a method to
engineering or architectural services per- that a taxpayer must determine deductions allocate gross receipts between DPGR and
formed by the taxpayer with regard to the allocated and apportioned to DPGR using non-DPGR, the taxpayer may not use a
same construction project, such receipts the rules of the regulations under § 861 different method for purposes of allocating
will be treated as DPGR. of the Code. Section 4.05(3) provides, CGS. In other cases, whether an alloca-
(13) Exception for sales of certain food however, that a taxpayer with average an- tion method is reasonable is based on all
and beverages. DPGR does not include nual gross receipts of $25,000,000 or less of the facts and circumstances including
gross receipts of the taxpayer that are de- may determine deductions apportionable the relationship between CGS and the base
rived from the sale of food or beverages to DPGR using the simplified deduction chosen; the accuracy of the method chosen
prepared by the taxpayer at a retail estab- method. Section 4.05(4) provides a simpli- as compared with other possible methods;
lishment. A “retail establishment” is de- fied overall method that a qualifying small whether the method is used by the tax-
fined as real property leased, occupied, or taxpayer may use to allocate and apportion payer for internal management and other
otherwise used by the taxpayer in its trade CGS and deductions to DPGR. Consistent business purposes; whether the method is
or business of selling food or beverages to with the rule in section 4.09(1) that treats used for other federal or state income tax
the public at which retail sales are made. A all members of an EAG as a single corpo- purposes; the availability of costing infor-
facility at which food or beverages are pre- ration for purposes of § 199, whether the mation; and the time, burden, and cost of
pared will not be treated as a retail estab- members of an EAG may use the simpli- using various methods. Depending on the
lishment if less than 5 percent of the food fied deduction method or the small busi- facts and circumstances, reasonable meth-
or beverages that are sold at that facility ness simplified overall method is deter- ods may include methods based on gross
during the taxable year are retail sales. If a mined at the EAG level. In addition, a receipts, number of units sold, number of
taxpayer’s facility is a retail establishment, member of an EAG that may use the sim- units produced, or total production costs.
then, as a matter of administrative grace, plified deduction method or the small busi- (c) Special rules for imported items
the taxpayer may allocate its gross receipts ness simplified overall method may do so or services. Under § 199(c)(3), the cost
between gross receipts derived from the re- only if all members of the EAG agree to of any item or service brought into the
tail sale of the food and beverages prepared and use the same method. United States is treated as not less than
and sold at the retail establishment (which (2) Cost of goods sold allocable to do- its value immediately after it entered the
are non-DPGR) and gross receipts derived mestic production gross receipts. (a) In United States for purposes of determining
from the wholesale sale of the food and general. Section 199(c)(1)(B)(i) requires a the CGS to be used in the computation
beverages prepared at the retail establish- taxpayer to reduce DPGR by the CGS di- of QPAI. When an item or service is
ment (which are DPGR). The exception for rectly allocable to DPGR. A taxpayer must brought into the United States that had
sales of certain food and beverages also ap- allocate CGS in accordance with this sec- been exported by the taxpayer for further
plies to food and beverages for non-human tion 4.05(2) of this notice or, if applica- manufacture, the increase in cost may not
consumption. ble, section 4.05(4). CGS is equal to be- exceed the difference between the value
(14) Related persons. Section 199(c)(7) ginning inventory plus purchases and pro- of the property when exported and the
provides that DPGR does not include any duction costs incurred during the taxable value of the property when brought back
gross receipts of the taxpayer derived from year less ending inventory. For purposes into the United States after further man-
property leased, licensed, or rented by the of § 199, CGS allocable to DPGR includes ufacture. For this purpose, the value of
taxpayer for use by any related person. A the costs that would have been included in property is its customs value as defined in
person is treated as related to another per- ending inventory under the principles of § 1059A(b)(1).
son if both persons are treated as a single §§ 263A, 471, and 472 if the goods sold (3) Other deductions allocable or
employer under either § 52(a) or (b) (with- during the taxable year were on hand at apportionable to domestic production
out regard to § 1563(b)), or § 414 (m) or the end of the taxable year. CGS alloca- gross receipts. (a) In general. Section
(o). ble to DPGR includes inventory valuation 199(c)(1)(B)(ii) and (iii) requires a tax-
.05 Determining Costs. (1) In gen- adjustments such as writedowns under the payer to reduce DPGR by deductions that
eral. To determine its QPAI for the taxable lower of cost or market method. For pur- are directly allocable to DPGR, and a
year, a taxpayer must reduce its DPGR poses of § 199, CGS also includes the ad- ratable portion of deductions that are not

February 14, 2005 521 2005–7 I.R.B.


directly allocable to DPGR or another non-DPGR as DPGR pursuant to a safe and 882(c)(1)(B)) must be ratably appor-
class of income. Any cost that may not be harbor or de minimis rule provided in this tioned between gross income attributable
taken into account in computing taxable notice (e.g., section 4.03(2) or section to DPGR and other gross income based on
income for the taxable year is not treated 4.04(10)(d) of this notice), deductions re- the relative amounts of gross income. For
as a deduction for purposes of this sec- lated to such non-DPGR treated as DPGR individuals, this provision applies solely
tion. A taxpayer generally must allocate must be allocated or apportioned to DPGR to deductions for charitable contributions
and apportion these deductions using the or gross income attributable to DPGR. that are attributable to the actual conduct
rules provided in the § 861 regulations, If the gross receipts related to embed- of a trade or business.
subject to the rules provided in this section ded services are included in DPGR under (iii) Research and experimental expen-
4.05(3) (the § 861 method). In lieu of the section 4.04(7), the deductions related to ditures. Research and experimental expen-
§ 861 method, a taxpayer with average an- providing such services must be allocated ditures must be allocated and apportioned
nual gross receipts of $25,000,000 or less or apportioned to DPGR or gross income in accordance with § 1.861–17. Because
may apportion these deductions using the attributable to DPGR. an apportionment based on geographic
simplified deduction method. A taxpayer (c) Section 861 method. (i) In gen- sources is not required for purposes of
electing the simplified deduction method eral. A taxpayer must allocate and ap- § 199, the exclusive apportionment rule of
must use that method for all deductions. portion its deductions using the allocation § 1.861–17(b) does not apply for purposes
See also section 4.05(4) for the small busi- and apportionment rules provided by the of the § 861 method.
ness simplified overall method available § 861 regulations, subject to the modifi- (d) Simplified deduction method. A
to a qualified small taxpayer. cations provided in section 4.05(3)(b)(ii) taxpayer with average annual gross re-
(b) Rules that apply to all alloca- through (v) and section 4.05(3)(c)(ii) and ceipts (as defined in section 4.05(5) of
tion and apportionment methods. (i) In (iii) of this notice. Under this method, this notice) of $25,000,000 or less may
general. The rules provided in section § 199 is treated as an “operative section” use the simplified deduction method.
4.05(3)(b)(ii) through (v) apply to losses, described in § 1.861–8(f). Accordingly, Under the simplified deduction method,
net operating losses, and certain other the taxpayer applies the rules of the § 861 except as provided in section 4.05(3)(b)
deductions when allocating and appor- regulations to allocate and apportion de- of this notice, a taxpayer’s deductions
tioning deductions to DPGR or gross ductions (including its distributive shares are ratably apportioned between DPGR
income attributable to DPGR under the of deductions) to gross income attributable and non-DPGR based on relative gross
§ 861 method (section 4.05(3)(c)), the to DPGR. Generally, the taxpayer allocates receipts. Accordingly, the amount of de-
simplified deduction method (section deductions to the relevant class of gross in- ductions apportioned to DPGR is equal
4.05(3)(d)), or the small business simpli- come and apportions (if necessary) such to the same proportion of the deductions
fied overall method (section 4.05(4)). deductions within the class of gross in- that the amount of DPGR bears to total
(ii) Losses. A deduction under § 165 come between gross income attributable to gross receipts. In the case of an owner of a
for a loss related to property (including DPGR (the statutory grouping) and other pass-thru entity, the simplified deduction
theft, casualty, or abandonment losses) is income (the residual grouping). The § 861 method (including whether the method
allocated or apportioned to DPGR or gross regulations generally are applied on a sin- may be used) is applied at the level of
income attributable to DPGR only if the gle entity basis, although the rules are ap- the owner of the pass-thru entity taking
proceeds from the sale of the property are, plied on the basis of the affiliated group (as into account the owner’s DPGR, receipts,
or would have been, included in DPGR. determined under the § 861 regulations) and other items from all sources including
(iii) Net operating losses. A deduc- for certain expenses such as interest ex- its distributive or allocable share of those
tion allowed under § 172 for a net oper- pense and research and experimental ex- items of the pass-thru entity.
ating loss is not allocated or apportioned penses. Consistent with these rules, alloca- (4) Small business simplified overall
to DPGR or gross income attributable to tion and apportionment of deductions gen- method. (a) In general. A qualifying
DPGR. erally are determined on an aggregate basis small taxpayer may use the small business
(iv) Deductions not attributable to the by the owner of the pass-thru entity. See simplified overall method to allocate and
actual conduct of a trade or business. De- for example, §§ 1.861–9T(e) and –17(f). apportion CGS and deductions between
ductions not attributable to the actual con- If the taxpayer uses the allocation and ap- DPGR and non-DPGR. Under the small
duct of a trade or business are not allocated portionment rules of the § 861 regulations business simplified overall method, a tax-
or apportioned to DPGR or gross income for another operative section of the Code, payer’s total CGS and deductions (except
attributable to DPGR. See § 199(d)(5). For it must use the same method of allocation as provided in section 4.05(3)(b) of this
example, the standard deduction provided and the same principles for apportionment notice) are ratably apportioned between
by § 63(c) and the deduction for personal for purposes of all operative sections (sub- DPGR and other receipts based on relative
exemptions provided by § 151 are not al- ject to, in the case of the § 861 method, gross receipts. Accordingly, the amount
located or apportioned to DPGR or gross the rules provided in section 4.05(3)(b)(ii) of CGS and deductions apportioned to
income attributable to DPGR. through (v) and section 4.05(3)(c)(ii) and DPGR is equal to the same proportion of
(v) Deductions related to de minimis (iii) of this notice). See § 1.861–8(f)(2)(i). CGS and deductions that the amount of
gross receipts and embedded services (ii) Deductions for charitable contribu- DPGR bears to total gross receipts.
included in domestic production gross re- tions. Deductions for charitable contribu- (b) Qualifying small taxpayer. For pur-
ceipts. If a taxpayer is permitted to treat tions (as allowed under §§ 170, 873(b)(2), poses of section 4.05(4)(a) of this notice,

2005–7 I.R.B. 522 February 14, 2005


a qualifying small taxpayer is a taxpayer in accordance with §§ 702 and 704, its computing its QPAI for that later taxable
that has average annual gross receipts (as share of items (including items of income, year.
described in section 4.05(5) of this notice) gain, loss, deduction, cost of goods sold (iii) W–2 wages. Under § 199(d)(1)(B),
of $5,000,000 or less or a taxpayer that is allocated to such items of income, and a partner’s share of W–2 wages of the part-
eligible to use the cash method as provided gross receipts that are included in such nership for purposes of determining the
in Rev. Proc. 2002–28, 2002–1 C.B. 815. items of income) allocated or attributable partner’s § 199(b) limitation is the lesser of
(That is, any taxpayer with average annual to the partnership’s activities described the partner’s allocable share of the wages
gross receipts of $10,000,000 or less that is in § 199(c)(4) (qualified production ac- (without regard to § 199(d)(1)(B)) as de-
not prohibited from using the cash method tivities), along with any other items of termined under regulations prescribed by
under § 448, including a partnership, an S income, gain, loss, deduction or credit of the Secretary, or 2 times 9 percent (3 per-
corporation, a C corporation, or an individ- the partnership. To determine its § 199 cent in the case of taxable years beginning
ual.) deduction for the taxable year, a partner in 2005 and 2006, and 6 percent in the
(5) Average annual gross receipts. aggregates its share of the items allocated case of taxable years beginning in 2007,
For purposes of the simplified deduction or attributable to the partnership’s qual- 2008, or 2009) of the QPAI computed tak-
method in section 4.05(3)(d) of this notice ified production activities, any expenses ing into account only the items of the part-
and the small business simplified overall incurred by the partner directly that are nership allocated to the partner for the tax-
method in section 4.05(4), average annual allocated to the partnership’s qualified able year of the partnership. In determin-
gross receipts means the average annual production activities, and those items of ing a partner’s share of the W–2 wages of
gross receipts of the taxpayer for the 3 the partner that are allocated or attrib- a partnership, allocations by the partner-
taxable years (or, if fewer, the taxable utable to qualified production activities ship of W–2 wages, otherwise meeting the
years during which the taxpayer was in from sources other than the partnership. A requirements of § 704(b), shall be taken
existence) preceding the current taxable partnership may specially allocate items into account by the partner for purposes of
year, even if one or more of such taxable of income, gain, loss, or deduction allo- § 199(d)(1)(B). Thus, a partner’s share of
years began before the effective date of cated or attributable to the partnership’s W–2 wages of the partnership is the lesser
§ 199. In the case of any taxable year of qualified production activities, subject to of the amount of W–2 wages allocated to
less than 12 months (a short taxable year), the rules of § 1.704–1(b), including the the partner under § 704, or 2 times the
the gross receipts shall be annualized by rules for determining substantial economic applicable percentage of the QPAI com-
(a) multiplying the gross receipts for the effect under § 1.704–1(b)(2)(iii). puted taking into account only the items of
short period by 12 and (b) dividing the (ii) Expenses. Each partner must take the partnership allocated to the partner for
result by the number of months in the into account the partner’s distributive the taxable year of the partnership, deter-
short period. Whether the members of an share of expenses allocated to the quali- mined at the partner level, in accordance
EAG may use the simplified deduction fied production activities of the partner- with section 4.06(1)(a)(i) and (ii), by ref-
method or the small business simplified ship, regardless of whether the partnership erence to the partner’s distributive or al-
overall method is determined by reference otherwise has taxable income. However, locable share of the partnership’s items of
to the average annual gross receipts of expenses of a partnership that otherwise income, gain, loss or deduction (including
the EAG. To compute the average annual would be taken into account for purposes gross receipts and costs of goods sold), al-
gross receipts of an EAG, the gross re- of computing the partner’s § 199 deduc- located or attributable to qualified produc-
ceipts of each member of the EAG for its tion shall only be taken into account if tion activities, and expenses incurred di-
taxable year that ends with or within the and to the extent the partner’s distributive rectly by the partner which are allocated to
taxable year of the computing member (as share of the losses and deductions from the partnership’s qualified production ac-
defined in section 4.09(8) of this notice) all of the partnership’s activities is not tivities, for the taxable year. Each partner
are aggregated, regardless of whether the disallowed by §§ 465, 469, 704(d), or any must aggregate the W–2 wages allocated
computing member or the non-computing other provision of the Code. In the event from the partnership with its W–2 wages
member was a member of the EAG during that only a portion of the partner’s dis- from other sources for purposes of com-
its entire taxable year. A member of an tributive share of the losses or deductions puting the partner’s § 199(b) limitation for
EAG that qualifies to use the simplified are allowed for a taxable year, a propor- the taxable year. However, if QPAI com-
deduction method or the small business tionate share of the losses or deductions puted taking into account only the items of
simplified overall method may do so only that reflect expenses allocated to the part- the partnership allocated to the partner for
if all members of the EAG agree to and nership’s qualified production activities, the taxable year is not greater than zero,
use the same method. determined in a manner consistent with the partner may not take into account any
.06 Application of § 199 to Pass-thru §§ 465, 469 and 704(d), shall be taken into W–2 wages of the partnership for purposes
Entities. (1) Allocations to partners, account for purposes of computing the of computing the wage limitation under
shareholders, and similar interest hold- § 199 deduction for that taxable year. To § 199(b) for the taxable year.
ers. (a) Partnerships. (i) Determination at the extent that any of the disallowed losses (b) S corporations. (i) Determination
partner level. The § 199 deduction is de- or deductions are allowed in a later taxable at S corporation shareholder level. The
termined at the partner level. As a result, year, the partner shall take into account § 199 deduction is determined at the share-
each partner must compute its deduc- a proportionate share of the expenses re- holder level. As a result, each shareholder
tion separately. Each partner is allocated, flected in those losses or deductions in must compute its deduction separately.

February 14, 2005 523 2005–7 I.R.B.


Each shareholder is allocated, in accor- shareholder’s allocable share of the wages spective § 199 deductions for their taxable
dance with § 1366, its pro rata share of (without regard to § 199(d)(1)(B)) as de- years ending December 31, 2006.
items (including items of income, gain, termined under regulations prescribed by .07 Patrons of Agricultural and Horti-
loss, and deduction) allocated or attribut- the Secretary, or 2 times 9 percent (3 per- cultural Cooperatives. Section 199(d)(3)
able to the qualified production activities cent in the case of taxable years beginning and this section 4.07 apply in the case of a
of the S corporation. To the extent that in 2005 and 2006, and 6 percent in the case cooperative (to which Part I of Subchapter
such items represent items relevant to of taxable years beginning in 2007, 2008, T applies), that is engaged in (1) the MPGE
the computation of the § 199 deduction or 2009) of the QPAI computed taking in whole or in significant part of any agri-
(for example, DPGR, CGS, other items into account only the items of the S cor- cultural or horticultural product, or (2) the
allocable to DPGR, or W–2 wages of the poration allocated to the shareholder for marketing of agricultural or horticultural
S corporation), the shareholder will take the taxable year. Each shareholder must products. Under § 199(d)(3) and this sec-
such items into account in computing its aggregate the W–2 wages allocated from tion, if any amount of a patronage dividend
§ 199 deduction. To compute its § 199 the S corporation with its W–2 wages from or qualified per-unit retain allocation paid
deduction for the taxable year, the share- other sources for purposes of computing in qualified per-unit retain certificates de-
holder will aggregate its pro rata share of its § 199(b) limitation for the taxable year. scribed in § 1385 is received by a patron
items allocated or attributable to the S cor- However, if the shareholder is not allo- from such a cooperative, and such amount
poration’s qualified production activities, cated positive QPAI computed taking into is allocable to QPAI of the cooperative that
and those items of the shareholder that account only the items of the S corporation is deductible under § 199(a) and section
are allocated or attributable to qualified allocated to the shareholder for the taxable 4.01 of this notice by the cooperative, then
production activities from sources other year, the shareholder may not take into the amount is deductible from the gross in-
than the S corporation. account any W–2 wages of the S corpora- come of the patron. Such an amount, how-
(ii) Expenses. Each shareholder must tion for purposes of computing the wage ever, does not reduce the taxable income of
take into account its pro rata share of ex- limitation under § 199(b) for the taxable the cooperative under § 1382. In order for
penses allocated to the qualified produc- year. the member to qualify for the deduction,
tion activities of the S corporation, regard- (2) Gain or loss from the disposition of § 199(d)(3)(A)(ii) requires the cooperative
less of whether the S corporation other- an interest in a pass-thru entity. QPAI gen- to designate the patron’s portion of the in-
wise has taxable income. However, ex- erally does not include gain or loss recog- come allocable to QPAI of the organization
penses of the S corporation that otherwise nized on the sale, exchange, or other dis- in a written notice mailed by the coopera-
would be taken into account for purposes position of an interest in the entity. How- tive to its patron during the payment period
of computing the shareholder’s § 199 de- ever, if § 751(a) or (b) applies, gain or described in § 1382(d) (that is, no later than
duction shall only be taken into account if loss allocable to assets of the partnership the 15th day of the ninth month following
and to the extent the shareholder’s pro rata the sale, exchange, or other disposition of the close of the taxable year). In determin-
share of the losses or deductions from all of which would give rise to QPAI is taken into ing the portion of the cooperative’s QPAI
the S corporation’s activities are not dis- account in computing the partner’s § 199 that would be deductible by the coopera-
allowed by §§ 465, 469, 1366(d), or any deduction. tive under § 199(a) and section 4.01, the
other provision of the Code. In the event (3) Effective date of § 199 for pass-thru cooperative’s taxable income is computed
that only a portion of the shareholder’s entities. Section 199(e) provides that § 199 without taking into account any deduction
pro rata share of the losses or deductions applies for taxable years beginning on or allowable under § 1382(b) or (c) relating
is allowed for a taxable year, a propor- after January 1, 2005. Accordingly, § 199 to patronage dividends, per-unit retain al-
tionate share of the losses or deductions does not apply to taxable years of pass-thru locations, and nonpatronage distributions
that reflect expenses allocated to the S cor- entities that begin before January 1, 2005. and, in the case of a cooperative engaged
poration’s qualified production activities, For example, assume a pass-thru entity has in the marketing of agricultural and horti-
determined in a manner consistent with a taxable year beginning July 1, 2004, and cultural products, the cooperative is treated
§§ 465, 469, and 1366(d), shall be taken ending June 30, 2005, and the owners of as having MPGE in whole or in significant
into account for purposes of computing the the pass-thru entity have taxable years be- part any QPP marketed by the cooperative
§ 199 deduction for that taxable year. To ginning January 1, 2005, and ending De- that its patrons have MPGE. For purposes
the extent that any of the disallowed losses cember 31, 2005. The provisions of § 199 of § 199, agricultural or horticultural prod-
or deductions are allowed in a later tax- do not apply to the pass-thru entity until ucts also include fertilizer, diesel fuel and
able year, the shareholder shall take into the first date of its first taxable year begin- other supplies used in agricultural or horti-
account a proportionate share of the ex- ning on or after January 1, 2005. Thus, cultural production that are MPGE by the
penses reflected in those losses or deduc- § 199 applies to the pass-thru entity for cooperative.
tions in computing its QPAI for that later its taxable year beginning July 1, 2005. .08 Individuals. In the case of individ-
taxable year. The owners of the pass-thru entity include uals, § 199(d)(2) provides that the deduc-
(iii) W–2 wages. Under § 199(d)(1)(B), their allocable or pro rata share of items tion is equal to the applicable percent of the
an S corporation shareholder’s share of allocated or attributable to the qualified lesser of the taxpayer’s (1) QPAI for the
W–2 wages of the S corporation for pur- production activities of the pass-thru en- taxable year, or (2) adjusted gross income
poses of determining the shareholder’s tity, for purposes of determining their re- (AGI) for the taxable year determined after
§ 199(b) limitation is the lesser of the

2005–7 I.R.B. 524 February 14, 2005


applying §§ 86, 135, 137, 219, 221, 222, whether the EAG member has taxable location of items must be made by using
and 469, and without regard to § 199. income or loss for the taxable year and the pro rata allocation method described in
.09 Expanded Affiliated Groups. (1) regardless of whether the EAG member section 4.09(6)(a)(i) of this notice. How-
In general. All members of an EAG are has W–2 wages. For this purpose, if a ever, the corporation may elect to use the
treated as a single corporation for purposes member has negative QPAI, the QPAI of closing of the books method described in
of § 199. An EAG is an affiliated group the member shall be treated as zero. section 4.09(6)(a)(ii).
as defined in § 1504(a), determined by (4) Special rules for consolidated (i) Pro rata allocation method. Under
substituting “50 percent” for “80 percent” groups. For purposes of § 199, a con- the pro rata allocation method, an equal
each place it appears, and without regard solidated group is treated as a single mem- portion of each of the taxable income or
to § 1504(b)(2) and (4). ber of the EAG. Therefore, if an EAG loss, QPAI, and W–2 wages for the taxable
(2) Computation of expanded affiliated includes corporations that are members year is assigned to each day of the corpora-
group’s § 199 deduction. (a) In general. of a consolidated group and corporations tion’s taxable year. Then, those items as-
The § 199 deduction for an EAG is de- that are not members of a consolidated signed to those days during which the cor-
termined by aggregating each member’s group, in computing the taxable income poration was a member of the EAG are ag-
taxable income or loss, QPAI, and W–2 limitation of the EAG, the consolidated gregated.
wages. For this purpose, a member’s QPAI taxable income of the consolidated group, (ii) Closing of the books method. Under
is the member’s DPGR less the sum of the not the separate taxable income of the the closing of the books method, taxable
CGS allocable to such receipts and other members of the consolidated group, is income or loss, QPAI, and W–2 wages for
costs required to be allocated under sec- taken into account. If all of the members the period during which the corporation
tion 4.05 of this notice. For purposes of of an EAG are members of the same con- was a member of the EAG are computed
this determination, a member’s QPAI may solidated group, the consolidated group’s by treating the corporation’s taxable year
be positive or negative. A member’s tax- § 199 deduction is determined based on as two separate taxable years, the first of
able income or loss and QPAI shall be the group’s consolidated taxable income which ends at the close of the day on which
determined by reference to the member’s or loss, not the separate taxable income or the corporation’s status as a member of
method of accounting. loss of its members. The § 199 deduction the EAG changes and the second of which
(b) Attribution of activities. Each mem- of a consolidated group (or the § 199 de- begins at the beginning of the day after
ber of an EAG is treated as conducting the duction allocated to a consolidated group the corporation’s status as a member of the
activities conducted by each other mem- that is a member of an EAG) must be allo- EAG changes.
ber of the EAG. For example, Corpora- cated to the members of the consolidated (iii) Making the § 199 closing of the
tion A and Corporation B are members of group in proportion to each consolidated books election. A corporation makes the
the same EAG but do not file a consoli- group member’s QPAI, if any, regardless § 199 closing of the books election by
dated return. A is engaged solely in the of whether the consolidated group member making the following statement: “The
trade or business of manufacturing QPP in has separate taxable income or loss for the § 199 closing of the books election is
the United States. B is a reseller of the taxable year and regardless of whether the hereby made with respect to [insert name
QPP manufactured by A. Without regard member has W–2 wages for the taxable of corporation and its employer identifica-
to the activities conducted by A, B would year. For purposes of allocating the § 199 tion number] with respect to the following
not qualify for the § 199 deduction. How- deduction of a consolidated group among periods [insert dates of two periods be-
ever, because B is a member of the EAG its members, if a consolidated group mem- tween which items are allocated pursuant
that includes A, B is treated as conducting ber has negative QPAI, the QPAI of the to the closing of the books method].” The
A’s manufacturing activities. Accordingly, member shall be treated as zero. statement must be filed with the corpora-
B’s gross receipts attributable to its sale of (5) Identification of members of the ex- tion’s timely filed (including extensions)
the QPP it purchases from A are DPGR panded affiliated group. A corporation federal income tax return for the taxable
(assuming all other requirements of § 199 must determine whether it is a member of year that includes the periods that are
are met). an EAG on a daily basis. If a corporation subject to the election. Once made, an
(c) Anti-avoidance rule. If a transaction becomes or ceases to be a member of an election under this section 4.09(6)(a)(iii)
between members of an EAG is engaged EAG, the corporation is treated as becom- is irrevocable.
in or structured with a principle purpose ing or ceasing to be a member of the EAG (b) Coordination with rules relat-
of qualifying for, or modifying the amount at the end of the day on which its status as ing to the allocation of income under
of, the § 199 deduction for one or more a member changes. § 1.1502–76(b). If § 1.1502–76 (relating
members of the EAG, adjustments must be (6) Allocation of income and loss. (a) to the taxable year of members of a consol-
made to eliminate the effect of the transac- In general. A corporation that is a mem- idated group) applies to a corporation that
tion on the computation of the § 199 de- ber of an EAG for only a portion of its tax- is a member of an EAG, any allocation of
duction. able year must allocate its taxable income items required under this section 4.09(6) is
(3) Allocation of expanded affiliated or loss, QPAI, and W–2 wages between the made only after the allocation of the cor-
group’s § 199 deduction. The EAG’s portion of the taxable year during which it poration’s items pursuant to § 1.1502–76.
§ 199 deduction is allocated among mem- is a member of the EAG and the portion (7) Total § 199 deduction for a corpo-
bers of the EAG in proportion to each of the taxable year during which it is not ration that is a member of an expanded af-
member’s QPAI, if any, regardless of a member of the EAG. In general, this al- filiated group for some or all of its taxable

February 14, 2005 525 2005–7 I.R.B.


year. If a corporation is a member of an the computing member are both members tion would have given rise to DPGR if
EAG for its entire taxable year, the cor- of the EAG and (2) taken into account in leased, rented, licensed, sold, exchanged,
poration’s § 199 deduction for the taxable a taxable year that begins after the effec- or otherwise disposed of by the target cor-
year is the amount of the § 199 deduction tive date of § 199 and ends with or within poration, then the assets will give rise to
allocated to the corporation by the EAG. If the taxable year of the computing member DPGR if leased, rented, licensed, sold, ex-
a corporation is a member of an EAG for a with respect to which the § 199 deduction changed, or otherwise disposed of by the
portion of its taxable year, and is either not is computed. acquiring corporation (assuming all other
a member of any EAG, or is a member of .10 Trade or Business Requirement. requirements of § 199(c) are met).
another EAG, or both, for another portion Section 199(d)(5) provides that § 199 is (4) Taxpayers with a 52–53 week tax-
of the taxable year, the corporation’s § 199 applied by taking into account only items able year. For purposes of applying
deduction for the taxable year is the sum that are attributable to the actual conduct § 1.441–2(c)(1) in the case of a taxpayer
of its § 199 deductions for each portion of of a trade or business. using a 52–53 week taxable year, any ref-
the taxable year. For example, Corpora- .11 Coordination with Alternative Mini- erence in § 199(a)(2) (the phase-in rule)
tions X and Y, calendar year corporations, mum Tax. Section 199(d)(6) provides rules to a taxable year “beginning after” a par-
are members of the same EAG for the en- to coordinate the deduction allowed under ticular calendar year means a taxable year
tire 2005 taxable year. Corporation Z, also § 199 with the AMT imposed by § 55. The beginning after December 31st of that
a calendar year corporation, is a member of deduction is allowed for purposes of the year. Similarly, any reference to a taxable
the EAG, of which X and Y are members, AMT, except that the deduction is equal to year “beginning in” a particular calendar
for the first half of 2005 and not a member the applicable percent of the lesser of the year means a taxable year beginning after
of any EAG for the second half of 2005. taxpayer’s: (1) QPAI, determined with- December 31st of the preceding calendar
During the 2005 taxable year, Z does not out regard to subchapter A, Part IV, of year. For example, a 52–53 week taxable
join in the filing of a consolidated return. the Code; or (2) AMTI (determined with- year that begins on December 26, 2004, is
Z makes a § 199 closing of the books elec- out regard to § 199), for the taxable year. deemed to begin on January 1, 2005, and
tion. As a result, Z has $100 of QPAI and For purposes of the preceding sentence, in the transition percentage for that taxable
$80 of taxable income that is allocated to the case of an individual, AGI (determined year is 3 percent.
the first half of the taxable year, and ($200) without regard to § 199) shall be substi-
of QPAI and a $150 taxable loss that is al- tuted for AMTI. SECTION 5. EFFECTIVE DATE
located to the second half of the taxable .12 Special rules. (1) Certain non-
This notice applies to taxable years be-
year. Taking into account Z’s QPAI and recognition transactions. Except as pro-
ginning after December 31, 2004.
taxable income allocated to the first half vided in section 4.09 of the notice (the
of the taxable year pursuant to the § 199 rules applicable to EAGs), if property is SECTION 6. REQUEST FOR
closing of the books election, the EAG has transferred by the taxpayer to an entity in a COMMENTS
positive QPAI and taxable income for the transaction to which § 351 or 721 applies,
taxable year and W–2 wages in excess of then whether the gross receipts derived .01 In General. The Service and Trea-
the § 199(b) wage limitation. Because the by the entity are DPGR shall be deter- sury Department invite taxpayers to sub-
EAG has both positive QPAI and taxable mined based on the activities performed mit written comments on issues relating to
income and sufficient W–2 wages, and be- by the entity without regard to the activi- § 199 and this notice. In particular, the Ser-
cause Z has positive QPAI for the first half ties performed by the taxpayer prior to the vice and Treasury Department encourage
of the year, a portion of the EAG’s § 199 contribution of the property to the entity. taxpayers to submit written comments on
deduction is allocated to Z. Z is allowed no (2) Section 1031 exchanges. If a tax- the following issues:
§ 199 deduction for the second half of the payer exchanges property for replacement (1) The Service and Treasury Depart-
taxable year. Thus, despite the fact that Z property in a transaction to which § 1031 ment are aware that several provisions of
has ($100) of QPAI and a $70 taxable loss applies, then whether the gross receipts de- the Code and regulations require computa-
for the entire 2005 taxable year, Z is still rived from the lease, rental, license, sale, tions based upon taxable income, and that
entitled to a § 199 deduction for the taxable exchange, or other disposition of the re- there is confusion concerning the order in
year equal to the § 199 deduction allocated placement property are DPGR shall be de- which these provisions are to be applied.
to Z as a member of the EAG. termined based solely on the activities per- Taxpayers are invited to submit a list of
(8) Computation of § 199 deduction for formed by the taxpayer. all provisions of the Code, regulations, and
members of expanded affiliated group with (3) Section 381 transactions. If a corpo- other administrative guidance (if any) that
different taxable years. If members of an ration (the acquiring corporation) acquires require computations based upon taxable
EAG have different taxable years, in de- the assets of another corporation (the tar- income, and the order in which taxpayers
termining the § 199 deduction of a member get corporation) in a transaction to which believe they should be applied;
(the “computing member”), with respect to § 381(a) applies, the acquiring corporation (2) The Service and Treasury Depart-
each group member, the computing mem- shall be treated as performing those ac- ment are concerned that there may be situ-
ber is required to take into account the tax- tivities of the target corporation with re- ations in which a contractor does not bear
able income or loss, QPAI, and W–2 wages spect to the acquired assets of the target the benefits and burdens of ownership with
that are both (1) attributable to the period corporation. Therefore, to the extent that respect to property (for example, for se-
during which the member of the EAG and the acquired assets of the target corpora- curity reasons), but nevertheless should

2005–7 I.R.B. 526 February 14, 2005


be regarded as satisfying the “by the tax- (7) The Service and Treasury Depart- Chief Counsel (Tax Exempt and Gov-
payer” requirement of § 199(c)(4)(A)(i). ment request comments related to the ap- ernment Entities) at (202) 622–6040 (not
Taxpayers are invited to submit comments plication of § 199 to computer software; toll-free calls).
on such situations; and
(3) The Service and Treasury Depart- (8) The Service and Treasury Depart-
ment request comments on the application ment invite comments on the appropri- Partnership Anti-Mixing Bowl
of §199 to trusts and estates. In partic- ateness of the $25,000,000 gross receipts Regulations
ular, comments are requested on whether threshold for use of the simplified deduc-
the apportionment of distributable net in- tion method. Notice 2005–15
come between the trust and estate and its .02 Addresses for Comments. Send
beneficiaries should govern the determina- submissions to: CC:PA:LPD:PR (Notice The Internal Revenue Service intends to
tion of the §199 deduction for the taxable 2005–14), room 5203, Internal Revenue promulgate regulations under §§ 704 and
year, what rules should apply if there is Service, PO Box 7604, Ben Franklin 737 of the Internal Revenue Code to ad-
no distributable net income for the taxable Station, Washington, DC 20044. Sub- dress the income tax consequences of dis-
year, how these rules should be applied missions may be hand-delivered Monday tributions of property following partner-
to split-interest trusts, and the information through Friday between the hours of ship mergers.
reporting requirements that should be im- 8 a.m. and 4 p.m. to CC:PA:LPD:PR (No-
posed on the trust or estate and its ben- tice 2005–14), Courier’s Desk, Internal BACKGROUND
eficiaries. Comments are also requested Revenue Service, 1111 Constitution Av-
Rev. Rul. 2004–43, 2004–18 I.R.B.
on the application of §199 to pass-thru en- enue, NW, Washington, DC. Submissions
842, holds that new § 704(c) gain or loss
tities other than partnerships, S corpora- may also be sent electronically via the
is created when assets are contributed by
tions, trusts and estates; Internet to the following e-mail address:
the transferor partnership to the con-
(4) The Service and Treasury Depart- Notice.comments@irscounsel.treas.gov.
tinuing partnership in an assets-over
ment request comments on whether tax- Include the notice number (Notice
merger. Rev. Rul. 2004–43 also holds
payers should be able to change any allo- 2005–14) in the subject line.
that § 704(c)(1)(B) applies to the newly
cation or apportionment method of gross .03 Deadline for Submission of Com-
created § 704(c) gain or loss in property
receipts or deductions on an amended re- ments. Comments must be received on or
contributed by the transferor partnership
turn and whether there should be restric- before March 31, 2005.
to the continuing partnership in an as-
tions on a taxpayer’s ability to change from
SECTION 7. DRAFTING sets-over partnership merger, but does not
one method to another;
INFORMATION apply to reverse § 704(c) gain or loss re-
(5) The Service and Treasury Depart-
sulting from a revaluation of property in
ment request comments on whether addi-
The principal authors of this notice are the continuing partnership. In addition,
tional modifications or clarifications to the
Paul Handleman and Lauren Ross Taylor Rev. Rul. 2004–43 holds that for purposes
§ 861 method would be appropriate, in-
of the Office of Associate Chief Counsel of § 737(b), net precontribution gain in-
cluding modifications relating to the deter-
(Passthroughs and Special Industries). For cludes the newly created § 704(c) gain or
mination of the “affiliated group” for pur-
further information regarding this notice, loss in property contributed by the trans-
poses of allocating and apportioning ex-
contact Mr. Handleman or Ms. Taylor at feror partnership to the continuing partner-
penses that are allocated and apportioned
(202) 622–3040 (not a toll-free call). For ship in an assets-over partnership merger,
on an affiliated group basis;
further information regarding the applica- but does not include reverse § 704(c) gain
(6) The Service and Treasury Depart-
tion of § 199 to pass-through entities, con- or loss resulting from a revaluation of
ment request comments regarding whether
tact James Quinn of the Office of Associate property in the continuing partnership.
members of an EAG should be required
Chief Counsel (Passthroughs and Special Some commentators have argued
to use the same method of allocating
Industries) at (202) 622–3080; regard- that Rev. Rul. 2004–43 is not consis-
and apportioning deductions to DPGR. If
ing the determination of costs generally, tent with the current regulations under
members of an EAG were to be able to
contact Scott Rabinowitz of the Office of §§ 704(c)(1)(B) and 737, and that the con-
use different methods of allocating and
Associate Chief Counsel (Income Tax and clusions in the ruling should not be applied
apportioning deductions, the Service and
Accounting) at (202) 622–4970; regard- retroactively. In response to these com-
Treasury Department request comments
ing the cost allocation rules under § 861, ments, the Treasury Department and the
regarding whether a member’s ability to
contact Bethany Ingwalson of the Office Service intend to issue regulations under
use the simplified deduction method or the
of Associate Chief Counsel (International) §§ 704(c)(1)(B) and 737 implementing the
small business simplified overall method
at (202) 622–3850; regarding expanded principles of the ruling. The regulations
should depend on the average annual gross
affiliated groups, contact Lisa Fuller of will be effective for distributions occur-
receipts of that member alone or the ag-
the Office of Associate Chief Counsel ring after January 19, 2005. Rev. Rul.
gregate average annual gross receipts of
(Corporate) at (202) 622–7750; or regard- 2005–10, published in this issue of the
all members of the EAG;
ing the definition of W–2 wages, contact Internal Revenue Bulletin, revokes Rev.
Alfred Kelley of the Office of Associate Rul. 2004–43.

February 14, 2005 527 2005–7 I.R.B.


DESCRIPTION OF REGULATIONS 2004–43, and, if so, under what circum- ing this notice, contact Ms. Fields at (202)
stances the exceptions should apply. Com- 622–3050 (not a toll-free call).
The regulations will apply the princi- ments are specifically requested regarding
ples of Rev. Rul. 2004–43 to distributions the application of §§ 704(c)(1)(B) and
of property following assets-over partner- 26 CFR 601.105: Examination of returns and claims
737, including the previously contributed for refund, credit, or abatement; determination of
ship mergers. The regulations will ap- property exception of § 737(d)(1), to a dis- correct tax liability.
ply to distributions of property with newly tribution of property, after an assets-over (Also Part 1, §§ 121, 1031; 1.121–1, 1.1031(a)–1.)
created § 704(c) gain or loss whether or partnership merger, to a partner who had
not that gain or loss is treated as reverse been a partner in the transferor partner- Rev. Proc. 2005–14
§ 704(c) gain or loss as the result of a ship, where the distributed property was
revaluation by the transferor partnership. held by the transferor partnership prior to
The regulations also will apply to distri- SECTION 1. PURPOSE
the merger. Comments are also requested
butions of property with original § 704(c) regarding whether the continuing partner-
gain or loss that existed upon contribution This revenue procedure provides guid-
ship may apply a § 704(c) method to orig-
to the transferor partnership. However, the ance on the application of §§ 121 and 1031
inal § 704(c) gain or loss that is different
regulations will provide that if the trans- of the Internal Revenue Code to a single
than the method applied by the transferor
feror partnership in an assets-over merger exchange of property.
partnership, and whether the continuing
holds contributed property with original partnership may apply a § 704(c) method SECTION 2. BACKGROUND
§ 704(c) gain or loss, the seven year pe- to newly created § 704(c) gain or loss that
riods in §§ 704(c)(1)(B) and 737 do not is different than the method that it applies .01 Section 121(a) provides that a tax-
restart with respect to that gain or loss as to original § 704(c) gain or loss. payer may exclude gain realized on the
a result of the merger. Comments are also requested regard- sale or exchange of property if the property
The regulations will provide that ing whether there are any additional issues was owned and used as the taxpayer’s prin-
§ 704(c)(1)(B) does not apply to newly that should be addressed in the regulations. cipal residence for at least 2 years during
created § 704(c) gain or loss in property For example, comments are requested re- the 5-year period ending on the date of the
contributed by the transferor partnership garding whether the regulations should sale or exchange. Section 121(b) provides
to the continuing partnership in an as- apply the principles of §§ 704(c)(1)(B) generally that the amount of the exclu-
sets-over partnership merger involving and 737 to reverse section 704(c) gain or sion is limited to $250,000 ($500,000 for
partnerships owned by the same owners loss. Comments are also requested regard- certain joint returns). Under § 121(d)(6),
in the same proportions. In addition, the ing whether the tiered partnership rule of any gain attributable to depreciation ad-
regulations will provide that for purposes § 1.704–3(a)(9) of the Income Tax Regu- justments (as defined in § 1250(b)(3)) for
of § 737, net precontribution gain does not lations should be modified or expanded to periods after May 6, 1997, is not eligible
include newly created § 704(c) gain or loss provide rules, similar to those applicable for the exclusion. This limitation applies
in property contributed by the transferor to assets-over partnership mergers, for the only to depreciation allocable to the por-
partnership to the continuing partnership application of §§ 704(c)(1)(B) and 737, as tion of the property to which the § 121 ex-
in an assets-over partnership merger in- well as § 704(c)(1)(A), to tiered partner- clusion applies. See § 121–1(d)(1).
volving partnerships owned by the same ship arrangements. .02 Section 121(d), as amended by
owners in the same proportions. In order Comments may be submitted on or § 840 of the American Jobs Creation Act
for merging partnerships to qualify for the before July 19, 2005, to Internal Revenue of 2004, Pub. L. 108–357, provides that,
exceptions described in this paragraph, Service, PO Box 7604, Washington, DC if a taxpayer acquired property in an ex-
each partner’s percentage interest in the 20044, Attn: CC:PA:LPD:PR (Notice change to which § 1031 applied, the § 121
transferor partnership’s capital, profits, 2005–15), Room 5203. Submissions may exclusion will not apply if the sale or ex-
losses, distributions, liabilities, and all also be hand-delivered Monday through change of the property occurs during the
other items must be the same as the part- Friday between the hours of 8 a.m. and 5-year period beginning on the date of the
ner’s percentage interest in those items of 4 p.m. to the Courier’s Desk at 1111 acquisition of the property. This provision
the continuing partnership. Constitution Avenue, NW, Washington is effective for sales or exchanges after
DC 20224, Attn: CC:PA:LPD:PR (No- October 22, 2004.
EFFECTIVE DATES tice 2005–15), Room 5203. Submissions .03 Under § 1.121–1(e) of the Income
may also be sent electronically via the Tax Regulations, a taxpayer who uses a
The regulations will be effective for
internet to the following email address: portion of a property for residential pur-
distributions from partnerships made after
Notice.comments@irscounsel.treas.gov. poses and a portion of the property for
January 19, 2005.
Include the notice number (Notice business purposes is treated as using the
REQUEST FOR COMMENTS 2005–15) in the subject line. entire property as the taxpayer’s princi-
The principal author of this notice is pal residence for purposes of satisfying the
Comments are requested regarding Laura Fields of the Office of Associate 2-year use requirement if the residential
whether there are any other commonly Chief Counsel (Passthroughs & Special In- and business portions of the property are
owned partnerships that should be ex- dustries). For further information regard- within the same dwelling unit. The term
cepted from the principles of Rev. Rul. “dwelling unit” has the same meaning as

2005–7 I.R.B. 528 February 14, 2005


in § 280A(f)(1), but does not include ap- 121(d)(5)(B), however, provides rules for this revenue procedure applies only to tax-
purtenant structures or other property. If, applying § 121 and another nonrecognition payers who satisfy the held for productive
however, the business portion of the prop- provision, § 1033, to a single replacement use in a trade or business or for investment
erty is separate from the dwelling unit used of property. Under § 1033, in general, gain requirement of § 1031(a)(1) with respect to
for residential purposes, the gain alloca- is recognized only to the extent the amount the relinquished business property and the
ble to the business portion of the property realized from a compulsory or involuntary replacement business property (as defined
is not excludable unless the taxpayer has conversion of property exceeds the cost below).
also met the 2-year use requirement for the of qualifying replacement property, and
business portion of the property. the basis of the replacement property is its SECTION 4. APPLICATION
.04 Section 1.121–1(e)(3) provides cost reduced by the amount of the gain not
that, for purposes of determining the recognized. .01 In general. Taxpayers within the
amount of gain allocable to the residential .09 Section 121(d)(5)(B) provides that, scope of this revenue procedure may ap-
and business portions of the property, the in applying § 1033, the amount realized ply both the exclusion of gain from the
taxpayer must allocate the basis and the from the sale or exchange of property is exchange of a principal residence under
amount realized using the same method treated as the amount determined without § 121 and the nonrecognition of gain from
of allocation the taxpayer used to deter- regard to § 121, reduced by the amount the exchange of like-kind properties under
mine depreciation adjustments (as defined of gain excluded under § 121. Under § 1031 to an exchange of property by ap-
in § 1250(b)(3)). Allocation based on § 121(d)(5)(B), the amount realized from plying the procedures set forth in this sec-
the square footage of the residential and an exchange of a taxpayer’s principal res- tion 4.
business portions of the property is an idence for purposes of applying § 1033 is .02 Computation of gain.
appropriate method of allocating the basis the fair market value of the relinquished (1) Application of § 121 before § 1031.
and the amount realized. Poague v. United property reduced by the amount of the Section 121 must be applied to gain real-
States, 66 A.F.T.R.2d (RIA) 5825 (E.D. gain excluded from gross income under ized before applying § 1031.
Va. 1990), aff’d, 947 F.2d 942 (4th Cir. § 121. Thus, Congress concluded that (2) Application of § 1031 to gain attrib-
1991). for exchanges meeting the requirements utable to depreciation. Under § 121(d)(6),
.05 Section 1031(a) provides that no of both § 121 and § 1033, (1) the § 121 the § 121 exclusion does not apply to gain
gain or loss is recognized on the exchange exclusion should be applied to gain from attributable to depreciation deductions for
of property held for productive use in a the exchange before the application of periods after May 6, 1997, claimed with re-
trade or business or for investment (re- § 1033, (2) for purposes of determining spect to the business or investment portion
linquished property) if the property is ex- gain that may be deferred under § 1033, of a residence. However, § 1031 may ap-
changed solely for property of like kind the § 121 exclusion should be applied first ply to such gain.
(replacement property) that is to be held ei- against amounts received by the taxpayer (3) Treatment of boot. In apply-
ther for productive use in a trade or busi- that are not reinvested in the replacement ing § 1031, cash or other non-like kind
ness or for investment. Under § 1031(b), property (amounts equivalent to boot that property (boot) received in exchange for
if a taxpayer also receives cash or prop- would result in gain recognition absent property used in the taxpayer’s trade or
erty that is not like-kind property (boot) in the application of § 121), and (3) the gain business or held for investment (the relin-
an exchange that otherwise qualifies un- excluded under § 121 should be added in quished business property), is taken into
der § 1031(a), the taxpayer must recog- the calculation of the taxpayer’s basis in account only to the extent the boot exceeds
nize gain to the extent of the boot. Section the replacement property. See S. Rep. No. the gain excluded under § 121 with respect
1031 does not apply to property that is used 830, 88th Cong., 2d Sess. 52–53, 1964–1 to the relinquished business property.
solely as a personal residence. C.B. (Part 2) 505, 556–7 (“the basis of the .03 Computation of basis. In determin-
.06 Section 1012 provides that the ba- taxpayer in the newly acquired residence ing the basis of the property received in
sis of property is its cost. The basis of will be his basis for the old residence in- the exchange to be used in the taxpayer’s
property acquired in an exchange is its fair creased by any exclusion of gain obtained trade or business or held for investment
market value, unless otherwise provided by him under the provision which is rein- (the replacement business property), any
in the Code or regulations (for example, vested in the new residence”); H.R. Rep. gain excluded under § 121 is treated as
§ 1031(d)). See Philadelphia Park Amuse- No. 749, 88th Cong., 1st Sess. 47, 1964–1 gain recognized by the taxpayer. Thus,
ment Co. v. United States, 126 F. Supp. C.B. (Part 2) 125, 171. under § 1031(d), the basis of the replace-
184 (Ct. Cl. 1954). ment business property is increased by any
.07 Under § 1031(d), the basis of the re- SECTION 3. SCOPE gain attributable to the relinquished busi-
placement property is the same as the basis ness property that is excluded under § 121.
of the relinquished property, decreased by This revenue procedure applies to tax-
the amount of cash received and increased payers who exchange property that satis- SECTION 5. EXAMPLES
by the amount of gain recognized by the fies the requirements for both the exclu-
taxpayer in the exchange. sion of gain from the exchange of a prin- In each example below, the taxpayer
.08 Neither § 121 nor § 1031 addresses cipal residence under § 121 and the non- is an unmarried individual and the prop-
the application of both provisions to a recognition of gain on the exchange of erty or a portion of the property has been
single exchange of property. Section like-kind properties under § 1031. Thus, used in the taxpayer’s trade or business or

February 14, 2005 529 2005–7 I.R.B.


held for investment within the meaning of for rental and cash satisfies the requirements of both of $30,000, including the $20,000 gain attributable
§ 1031(a) as well as used as a principal res- §§ 121 and 1031. Section 121 does not require the to depreciation, under § 1031. See section 4.02(2)
idence as required under § 121. property to be the taxpayer’s principal residence on of this revenue procedure. Although A receives
the sale or exchange date. Because A owns and uses $10,000 of cash (boot) in the exchange, A is not
Example 1. (i) Taxpayer A buys a house for
the house as A’s principal residence for at least 2 years required to recognize gain because the boot is taken
$210,000 that A uses as A’s principal residence from
2000 to 2004. From 2004 until 2006, A rents the during the 5-year period prior to the exchange, A may into account for purposes of § 1031(b) only to the
exclude gain under § 121. Because the house is in- extent the boot exceeds the amount of excluded gain.
house to tenants and claims depreciation deductions
vestment property at the time of the exchange, A may See section 4.02(3) of this revenue procedure.
of $20,000. In 2006, A exchanges the house for
$10,000 of cash and a townhouse with a fair market defer gain under § 1031. These results are illustrated as follows.
(iii) Under section 4.02(1) of this revenue pro-
value of $460,000 that A intends to rent to tenants.
cedure, A applies § 121 to exclude $250,000 of the
A realizes gain of $280,000 on the exchange.
(ii) A’s exchange of a principal residence that A $280,000 gain before applying the nonrecognition
rules of § 1031. A may defer the remaining gain
rents for less than 3 years for a townhouse intended

Amount realized ................................. $470,000


Less: Adjusted basis . . . . . . . . . . . . . . . . . . . . $190,000
Realized gain . . . . . . . . . . . . . . . . . . . . . $280,000
Less: Gain excluded under § 121 . . . . . . . . . . $250,000
Gain to be deferred . . . . . . . . . . . . . . . . . $30,000

(iv) A’s basis in the replacement property is guesthouse. In 2006, B exchanges the entire property of the property. Because the guesthouse is business
$430,000, which is equal to the basis of the re- for a residence and a separate property that B intends property separate from the dwelling unit and B has
linquished property at the time of the exchange to use as an office. The total fair market value of B’s not met the use requirements for the guesthouse,
($190,000) increased by the gain excluded under replacement properties is $360,000. The fair market B may not exclude the gain allocable to the guest-
§ 121 ($250,000), and reduced by the cash A re- value of the replacement residence is $240,000 and house under § 1.121–1(e). However, because the fair
ceives ($10,000)). See section 4.03 of this revenue the fair market value of the replacement business market value of the replacement business property
procedure. property is $120,000, which is equal to the fair mar- is equal to the fair market value of the relinquished
Example 2. (i) Taxpayer B buys a prop- ket value of the relinquished business property. From business property and B receives no boot, B may
erty for $210,000. The property consists of two 2001 to 2006, B claims depreciation deductions of defer the remaining gain of $80,000 (1/3 of $360,000
separate dwelling units (within the meaning of $30,000 for the business use. B realizes gain of amount realized, or $120,000, minus $40,000 ad-
§ 1.121–1(e)(2)), a house and a guesthouse. From $180,000 on the exchange. justed basis, which is 1/3 of $210,000 basis, or
2001 until 2006, B uses the house as B’s principal (ii) Under § 121, B may exclude gain of $100,000 $70,000, adjusted by $30,000 depreciation) under
residence and uses the guesthouse as an office in B’s allocable to the residential portion of the house (2/3 § 1031.
trade or business. Based on the square footage of the of $360,000 amount realized, or $240,000, minus These results are illustrated as follows:
respective parts of the property, B allocates 2/3 of 2/3 of $210,000 basis, or $140,000) because B meets
the basis of the property to the house and 1/3 to the the ownership and use requirements for that portion

Total property 2/3 residential property 1/3 business property


Amount realized $360,000 $240,000 $120,000
Basis $210,000 $140,000 $ 70,000
Depreciation adjustment $ 30,000 $ 30,000
Adjusted basis $180,000 $140,000 $ 40,000
Realized gain $180,000 $100,000 $ 80,000
Gain excluded under § 121 $100,000 $100,000
Gain deferred under § 1031 $ 80,000 $ 80,000

(iii) Because no portion of the gain attributable 1/3 of the house as an office in C’s trade or business. minus 2/3 of $210,000 basis, or $140,000) because
to the relinquished business property is excluded un- In 2006, C exchanges the entire property for a resi- C meets the ownership and use requirements for that
der § 121 and B receives no boot and recognizes no dence and a separate property that C intends to use as portion of the property.
gain or loss in the exchange, B’s basis in the replace- an office in C’s trade or business. The total fair mar- (iii) The remaining gain of $80,000 (1/3 of
ment business property is equal to B’s basis in the ket value of C’s replacement properties is $360,000. $360,000 amount realized, or $120,000, minus
relinquished business property at the time of the ex- The fair market value of the replacement residence $40,000 adjusted basis, which is 1/3 of $210,000
change ($40,000). B’s basis in the replacement res- is $240,000 and the fair market value of the replace- basis, or $70,000, adjusted by $30,000 depreciation)
idential property is the fair market value of the re- ment business property is $120,000, which is equal is allocable to the business portion of the house
placement residential property at the time of the ex- to the fair market value of the business portion of the (the office). Under section 4.02(1) of this revenue
change ($240,000). relinquished property. From 2001 to 2006, C claims procedure, C applies § 121 before applying the non-
Example 3. (i) Taxpayer C buys a property for depreciation deductions of $30,000 for the business recognition rules of § 1031. Under § 1.121–1(e),
$210,000. The property consists of a house that con- use. C realizes gain of $180,000 on the exchange. C may exclude $50,000 of the gain allocable to the
stitutes a single dwelling unit under § 1.121–1(e)(2). (ii) Under § 121, C may exclude the gain of office because the office and residence are part of a
From 2001 until 2006, C uses 2/3 of the house (by $100,000 allocable to the residential portion of the single dwelling unit. C may not exclude that portion
square footage) as C’s principal residence and uses house (2/3 of $360,000 amount realized, or $240,000, of the gain ($30,000) attributable to depreciation

2005–7 I.R.B. 530 February 14, 2005


deductions, but may defer the remaining gain of These results are illustrated as follows:
$30,000 under § 1031.

Total property 2/3 residential property 1/3 business property


Amount realized $360,000 $240,000 $120,000
Basis $210,000 $140,000 $ 70,000
Depreciation adjustment $ 30,000 $ 30,000
Adjusted basis $180,000 $140,000 $ 40,000
Realized gain $180,000 $100,000 $ 80,000
Gain excluded under § 121 $150,000 $100,000 $ 50,000
Gain deferred under § 1031 $ 30,000 $ 30,000

(iv) C’s basis in the replacement residential ment business property is $110,000, which is $10,000 Under § 1.121–1(e), C may exclude $50,000 of the
property is the fair market value of the replacement less than the fair market value of the business portion gain allocable to the business portion of the house
residential property at the time of the exchange of the relinquished property ($120,000). but may not exclude the $30,000 of gain attributable
($240,000). C’s basis in the replacement business (ii) Under § 121, C may exclude the gain of to depreciation deductions. Under section 4.02(2)
property is $90,000, which is equal to C’s basis in $100,000 allocable to the residential portion of the of this revenue procedure, C may defer the $30,000
the relinquished business property at the time of the house (2/3 of $360,000 amount realized, or $240,000, of gain under § 1031. Although C receives $10,000
exchange ($40,000), increased by the gain excluded minus 2/3 of $210,000 basis, or $140,000). of cash (boot) in the exchange, C is not required to
under § 121 attributable to the relinquished business (iii) The remaining gain of $80,000 (1/3 of recognize gain because the boot is taken into account
property ($50,000). See section 4.03 of this revenue $360,000 amount realized, or $120,000, minus for purposes of § 1031(b) only to the extent the boot
procedure. $40,000 adjusted basis) is allocable to the business exceeds the amount of excluded gain attributable to
Example 4. (i) The facts are the same as in Exam- portion of the house. Under section 4.02(1) of this the relinquished business property. See 4.02(3) of
ple 3 except that C also receives $10,000 of cash in revenue procedure, C applies § 121 to exclude gain this revenue procedure.
the exchange and the fair market value of the replace- before applying the nonrecognition rules of § 1031. These results are illustrated as follows:

Total property 2/3 residential property 1/3 business property


Amount realized $360,000 $240,000 $110,000 + 10,000
Basis $210,000 $140,000 $ 70,000
Depreciation adjustment $ 30,000 $ 30,000
Adjusted basis $180,000 $140,000 $ 40,000
Realized gain $180,000 $100,000 $ 80,000
Gain excluded under § 121 $150,000 $100,000 $ 50,000
Gain deferred under § 1031 $ 30,000 $ 30,000

(iv) C’s basis in the replacement residential value of the replacement residence is $360,000, the revenue procedure, C excludes the gain before ap-
property is the fair market value of the replacement fair market value of the replacement business prop- plying the nonrecognition rules of § 1031. Under
residential property at the time of the exchange erty is $180,000, and C realizes gain of $360,000 on § 1.121–1(e), C may exclude $30,000 of the gain
($240,000). C’s basis in the replacement business the exchange. allocable to the business portion, at which point C
property is $80,000, which is equal to C’s basis in the (ii) Under § 121, C may exclude the gain of will have excluded the maximum limitation amount
relinquished business property ($40,000), increased $220,000 allocable to the residential portion of the of $250,000. C may defer the remaining gain of
by the gain excluded under § 121 ($50,000), and house (2/3 of $540,000 amount realized, or $360,000, $110,000 ($140,000 realized gain minus the $30,000
reduced by the cash ($10,000) received. See section minus 2/3 of $210,000 basis, or $140,000). gain excluded under § 121), including the $30,000
4.03 of this revenue procedure. (iii) The remaining gain of $140,000 (1/3 of gain attributable to depreciation, under § 1031.
Example 5. (i) The facts are the same as in Ex- $540,000 amount realized, or $180,000, minus These results are illustrated as follows:
ample 3 except that the total fair market value of the $40,000 adjusted basis) is allocable to the business
replacement properties is $540,000. The fair market portion of the house. Under section 4.02(1) of this

February 14, 2005 531 2005–7 I.R.B.


Total property 2/3 residential property 1/3 business property
Amount realized $540,000 $360,000 $180,000
Basis $210,000 $140,000 $ 70,000
Depreciation adjustment $ 30,000 $ 30,000
Adjusted basis $180,000 $140,000 $ 40,000
Realized gain $360,000 $220,000 $140,000
Gain excluded under § 121 $250,000 $220,000 $ 30,000
Gain deferred under § 1031 $110,000 $110,000

(iv) C’s basis in the replacement residential replacement properties is $750,000. The fair market of $110,000 allocable to the residential portion that
property is the fair market value of the replacement value of the replacement residence is $500,000, the exceeds the § 121(b) exclusion limitation amount.
residential property at the time of the exchange fair market value of the replacement business prop- (iii) The remaining gain of $210,000 (1/3 of
($360,000). C’s basis in the replacement business erty is $250,000, and C realizes gain of $570,000 on $750,000 amount realized, or $250,000, minus
property is $70,000, which is equal to C’s basis in the exchange. $40,000 adjusted basis) is allocable to the business
the relinquished business property ($40,000), in- (ii) The gain allocable to the residential portion portion of the house. C may defer the $210,000
creased by the amount of the gain excluded under is $360,000 (2/3 of $750,000 amount realized, or of gain, including the $30,000 gain attributable to
§ 121 ($30,000). See section 4.03 of this revenue $500,000, minus 2/3 of $210,000 basis, or $140,000). depreciation, under § 1031.
procedure. C may exclude gain of $250,000 from gross income These results are illustrated as follows:
Example 6. (i) The facts are the same as in Ex- under § 121. C must include in income the gain
ample 3 except that the total fair market value of the

Total property 2/3 residential property 1/3 business property


Amount realized $750,000 $500,000 $250,000
Basis $210,000 $140,000 $ 70,000
Depreciation adjustment $ 30,000 $ 30,000
Adjusted basis $180,000 $140,000 $ 40,000
Realized gain $570,000 $360,000 $210,000
Gain excluded under § 121 $250,000 $250,000
Gain deferred under § 1031 $210,000 $210,000
Gain recognized $110,000 $110,000

(iv) C’s basis in the replacement residential apply this revenue procedure in taxable information regarding this revenue pro-
property is the fair market value of the replacement years for which the period of limitation on cedure, contact Ms. Shepherd at (202)
residential property at the time of the exchange
refund or credit under § 6511 has not ex- 622–4960 (not a toll-free call).
($500,000). C’s basis in the replacement business
property is $40,000, which is equal to C’s basis in
pired.
the relinquished business property at the time of the
exchange. DRAFTING INFORMATION

SECTION 6. EFFECTIVE DATE The principal author of this revenue


procedure is Sara Paige Shepherd of the
This revenue procedure is effective Jan- Office of Associate Chief Counsel (In-
uary 27, 2005. However, taxpayers may come Tax & Accounting). For further

2005–7 I.R.B. 532 February 14, 2005


Part IV. Items of General Interest
Amendment of Previously Constitution Avenue, NW, Washington, [68 FR 3477]), cross-referencing tempo-
Proposed Regulations and DC. rary regulations (T.D. 9038, 2003–1, C.B.
Notice of Public Hearing 524 [68 FR 3384]) (January 24, 2003).
FOR FURTHER INFORMATION Many foreign jurisdictions now have
CONTACT: Concerning the proposed reg- merger or consolidation statutes that op-
Statutory Mergers and ulations, Vincent Daly, (202) 622–7770; erate in material respects like those of the
Consolidations concerning submissions, the hearing, or states, i.e., all assets and liabilities move
placement on the building access list to by operation of law. The Treasury De-
REG–117969–00 attend the hearing, Robin Jones, (202) partment and IRS believe that transactions
622–7180 (not toll-free numbers). effected pursuant to these statutes should
AGENCY: Internal Revenue Service
be treated as reorganizations if they satisfy
(IRS), Treasury. SUPPLEMENTARY INFORMATION: the functional criteria applicable to trans-
ACTION: Amendment of previously pro- actions under domestic statutes.
Background and Explanation of This document proposes a revised def-
posed regulations and notice of public Provisions
hearing. inition of a statutory merger or consolida-
tion. The previously proposed definition
Before 1934, the term merger, as used
SUMMARY: This document amends pre- of a statutory merger required that it be a
in the reorganization provisions, included
viously proposed regulations published in transaction effected “pursuant to the laws
statutory mergers as well as other combi-
the Federal Register on January 24, 2003 of the United States or a State or the Dis-
nations of corporate entities. In 1934, Con-
(REG–126485–01, 2003–1 C.B. 542, 68 trict of Columbia.” See REG–126485–01
gress amended the definition of a reorga-
FR 3477) by cross-reference to temporary (2003–1 C.B. 542 [68 FR 3477]). The
nization to provide separately for statutory
regulations. Those regulations define the new proposed definition contained in this
mergers or consolidations and for the other
term statutory merger or consolidation as document replaces the quoted language
types of transactions previously included
that term is used in section 368(a)(1)(A). with “pursuant to the statute or statutes
in the definition of a merger. There is no
This notice of proposed rulemaking affects necessary to effect the merger or con-
indication in the legislative history of the
corporations engaging in mergers and con- solidation.” This proposed change would
1934 changes to the definition of a reorga-
solidations and their shareholders. It is be- allow a transaction effected pursuant to
nization that Congress intended to exclude
ing issued concurrently with proposed reg- the statutes of a foreign jurisdiction or of
transactions effected under foreign law.
ulations under sections 358, 367, and 884. a United States possession to qualify as
In 1935, Treasury regulations inter-
(See REG–125628–01 in this issue of the a statutory merger or consolidation under
preted the term statutory merger under
Bulletin). section 368(a)(1)(A), provided it other-
the revised provision to mean a merger
wise qualifies as a reorganization. The
DATES: Written and electronic comments or consolidation effected pursuant to the
phrase statute or statutes is not intended
and requests to speak and outlines of top- corporation laws of a State or Territory
to prevent transactions effected pursuant
ics to be discussed at the public hearing or the District of Columbia. The require-
to legislation from qualifying as mergers
scheduled for May 19, 2005, to be held in ment that the transaction be effected under
or consolidations where such legislation
the IRS Auditorium (7th Floor) must be re- domestic law remains in place, with mi-
is supplemented by administrative or case
ceived by April 28, 2005. nor variations. The Treasury Department
law.
and IRS believe that this interpretation
This notice of proposed rule-
ADDRESSES: Send submissions to is reasonable; nevertheless, the Treasury
making also proposes to remove
CC:PA:LPD:PR (REG–117969–00), Department and IRS believe that a re-
§1.368–2(b)(1)(iii) of the previously pro-
Room 5203, Internal Revenue Ser- examination is warranted in light of the
posed regulations. That section imposes
vice, POB 7604, Ben Franklin Sta- purposes of the statute and changes in
limitations on the use of disregarded enti-
tion, Washington, DC 20044. Submis- domestic and foreign law since 1935.
ties in statutory mergers or consolidations
sions may be hand delivered Monday The states have revised their laws to of-
when certain entities are not organized
through Friday between the hours of fer a greater variety of business entities
under the laws of the United States or a
8 a.m. and 4 p.m. to: CC:PA:LPD:PR and greater flexibility in effecting busi-
State or the District of Columbia.
(REG–117969–00), Courier’s Desk, In- ness combinations. Accordingly, the Trea-
Although this document revises the
ternal Revenue Service, 1111 Constitution sury Department and IRS thought it ad-
terms of the proposed definition of a statu-
Avenue, NW, Washington, DC, or sent visable to define a merger or consolida-
tory merger or consolidation for purposes
electronically, via the IRS Internet site at tion functionally, to supplement the refer-
of section 368, the provisions of the tem-
www.irs.gov/regs or via the Federal eRule- ence to state law. Accordingly, the Trea-
porary regulations will remain in effect
making Portal at www.regulations.gov sury Department and IRS developed and
until this proposal is incorporated in tem-
(IRS-REG–117969–00). The public hear- proposed such a functional definition in
porary or final regulations after notice and
ing will be held in the IRS Auditorium (7th 2003. See Notice of Proposed Rulemak-
comment.
Floor), Internal Revenue Building, 1111 ing (REG–126485–01, 2003–1 C.B. 542

February 14, 2005 533 2005–7 I.R.B.


Section 1.368–2(b)(1)(B)(iv), Exam- Comments and Public Hearing Proposed Amendments to the
ples 1 and 2 in the previously proposed Regulations
regulations each specified that one of Before these proposed regulations are
the parties to the transaction described adopted as final regulations, consideration Accordingly, 26 CFR part 1 is proposed
in the example “is not treated as own- will be given to any written comments to be amended as follows:
ing any assets of an entity that is dis- (a signed original and eight (8) copies)
or electronic comments that are submitted PART 1—INCOME TAXES
regarded as an entity separate from its
owner for Federal tax purposes.” The timely to the IRS. The IRS and Treasury
Paragraph 1. The authority citation for
results in those examples would be the Department specifically request comments
part 1 continues to read, in part, as follows:
same in each case whether or not a party on the clarity of the proposed regulations
Authority: 26 U.S.C. 7805 * * *
to the transaction held such assets. See and on how they can be made easier to un-
Par. 2. Paragraph (b)(1) of §1.368–2
§1.368–2(b)(1)(B)(iv), Example 3 in the derstand. All comments will be available
as proposed on January 24, 2003, at 68 FR
previously proposed regulations. To avoid for public inspection and copying.
3477, is proposed to be revised to read as
any possible implication to the contrary, A public hearing has been scheduled for
follows:
the Treasury Department and IRS propose May 19, 2005, beginning at 10 a.m. in the
removal of the sentence specifying that IRS Auditorium (7th Floor), Internal Rev- §1.368–2 Definition of terms.
condition from each example. The Trea- enue Building, 1111 Constitution Avenue,
sury Department and IRS are continuing NW, Washington, DC. Due to building se- *****
to study other comments received on the curity procedures, visitors must enter at the (b)(1)(i) Definitions. The following
earlier proposed regulations. Constitution Avenue entrance. In addition, definitions apply for purposes of this para-
A notice of proposed rulemaking all visitors must present photo identifica- graph (b)(1):
proposing amendments to the regulations tion to enter the building. Because of ac- (A) Disregarded entity. A disregarded
under sections 358, 367, and 884 (includ- cess restrictions, visitors will not be ad- entity is a business entity (as defined in
ing special rules for determining basis and mitted beyond the immediate entrance area §301.7701–2(a) of this chapter) that is
holding period in certain transactions in- more than 30 minutes before the hearing disregarded as an entity separate from its
volving one or more foreign corporations) starts. For information about having your owner for Federal tax purposes. Examples
is being published simultaneously with name placed on the building access list of disregarded entities include a domestic
the publication of this notice of proposed to attend the hearing, see the FOR FUR- single member limited liability company
rulemaking. See REG–125628–01 in this THER INFORMATION CONTACT por- that does not elect to be classified as a
issue of the Bulletin. tion of this preamble. corporation for Federal tax purposes, a
The rules of 26 CFR 601.601(a)(3) ap- corporation (as defined in §301.7701–2(b)
Proposed Effective Date ply to the hearing. Persons who wish to of this chapter) that is a qualified REIT
present oral comments must submit writ- subsidiary (within the meaning of section
These regulations are proposed to apply ten or electronic comments and an out- 856(i)(2)), and a corporation that is a qual-
to transactions occurring after the date fi- line of the topics to be discussed and the ified subchapter S subsidiary (within the
nal regulations are published in the Fed- time to be devoted to each topic (a signed meaning of section 1361(b)(3)(B)).
eral Register. original and eight (8) copies) by April 28, (B) Combining entity. A combining en-
2005. A period of 10 minutes will be tity is a business entity that is a corporation
Special Analyses allotted to each person for making com- (as defined in §301.7701–2(b) of this chap-
ments. An agenda showing the scheduling ter) that is not a disregarded entity.
It has been determined that this notice of the speakers will be prepared after the (C) Combining unit. A combining unit
of proposed rulemaking is not a significant deadline for receiving outlines has passed. is composed solely of a combining entity
regulatory action as defined in Executive Copies of the agenda will be available free and all disregarded entities, if any, the as-
Order 12866. Therefore, a regulatory as- of charge at the hearing. sets of which are treated as owned by such
sessment is not required. It also has been combining entity for Federal tax purposes.
determined that section 553(b) of the Ad- Drafting Information (ii) Statutory merger or consolida-
ministrative Procedure Act (5 U.S.C. chap- tion generally. For purposes of section
The principal author of these regula-
ter 5) does not apply to these regulations. 368(a)(1)(A), a statutory merger or consol-
tions is Vincent Daly, Office of the As-
Because the regulations do not impose a idation is a transaction effected pursuant
sociate Chief Counsel (Corporate). How-
collection of information on small entities, to the statute or statutes necessary to ef-
ever, other personnel from the IRS and
the Regulatory Flexibility Act (5 U.S.C. fect the merger or consolidation, in which
Treasury Department participated in their
chapter 6) does not apply. Pursuant to sec- transaction, as a result of the operation
development.
tion 7805(f) of the Internal Revenue Code, of such statute or statutes, the following
this notice of proposed rulemaking will be ***** events occur simultaneously at the effec-
submitted to the Chief Counsel for Advo- tive time of the transaction—
cacy of the Small Business Administration (A) All of the assets (other than those
for comment on its impact on small busi- distributed in the transaction) and liabili-
ness. ties (except to the extent satisfied or dis-

2005–7 I.R.B. 534 February 14, 2005


charged in the transaction) of each mem- all purposes. In the merger, the Z shareholders ex- Example 5. Merger of a target corporation into a
ber of one or more combining units (each change their stock of Z for stock of Y. disregarded entity owned by a partnership. (i) The
a transferor unit) become the assets and li- (ii) The transaction satisfies the requirements of facts are the same as in Example 2, except that Y
paragraph (b)(1)(ii) of this section because the trans- is organized as a partnership under the laws of State
abilities of one or more members of one action is effected pursuant to State W law and the W and is classified as a partnership for Federal tax
other combining unit (the transferee unit); following events occur simultaneously at the effec- purposes.
and tive time of the transaction: all of the assets and li- (ii) The transaction does not satisfy the require-
(B) The combining entity of each trans- abilities of Z, the combining entity and sole member ments of paragraph (b)(1)(ii)(A) of this section. All
feror unit ceases its separate legal exis- of the transferor unit, become the assets and liabil- of the assets and liabilities of Z, the combining entity
ities of one or more members of the transferee unit and sole member of the transferor unit, do not become
tence for all purposes; provided, however, that is comprised of Y, the combining entity of the the assets and liabilities of one or more members of
that this requirement will be satisfied even transferee unit, and X, a disregarded entity the assets a transferee unit because neither X nor Y qualifies as
if, under applicable law, after the effective of which Y is treated as owning for Federal tax pur- a combining entity. Accordingly, the transaction can-
time of the transaction, the combining en- poses, and Z ceases its separate legal existence for all not qualify as a statutory merger or consolidation for
tity of the transferor unit (or its officers, purposes. Accordingly, the transaction qualifies as a purposes of section 368(a)(1)(A).
statutory merger or consolidation for purposes of sec- Example 6. Merger of a disregarded entity into a
directors, or agents) may act or be acted tion 368(a)(1)(A). corporation. (i) Under State W law, X merges into Z.
against, or a member of the transferee unit Example 3. Merger of a target S corporation that Pursuant to such law, the following events occur si-
(or its officers, directors, or agents) may owns a QSub into a disregarded entity. (i) The facts multaneously at the effective time of the transaction:
act or be acted against in the name of are the same as in Example 2, except that Z is an S all of the assets and liabilities of X (but not the assets
the combining entity of the transferor unit, corporation and owns all of the stock of U, a QSub. and liabilities of Y other than those of X) become the
(ii) The deemed formation by Z of U pursuant assets and liabilities of Z and X’s separate legal exis-
provided that such actions relate to assets to §1.1361–5(b)(1) (as a consequence of the termi- tence ceases for all purposes.
or obligations of the combining entity of nation of U’s QSub election) is disregarded for Fed- (ii) The transaction does not satisfy the require-
the transferor unit that arose, or relate to eral income tax purposes. The transaction is treated ments of paragraph (b)(1)(ii)(A) of this section be-
activities engaged in by such entity, prior as a transfer of the assets of U to X, followed by X’s cause all of the assets and liabilities of a transferor
to the effective time of the transaction, and transfer of these assets to U in exchange for stock unit do not become the assets and liabilities of one or
of U. See §1.1361–5(b)(3), Example 9. The transac- more members of the transferee unit. The transaction
such actions are not inconsistent with the tion will, therefore, satisfy the requirements of para- also does not satisfy the requirements of paragraph
requirements of paragraph (b)(1)(ii)(A) of graph (b)(1)(ii) of this section because the transac- (b)(1)(ii)(B) of this section because X does not qual-
this section. tion is effected pursuant to State W law and the fol- ify as a combining entity. Accordingly, the transac-
(iii) Examples. The following examples lowing events occur simultaneously at the effective tion cannot qualify as a statutory merger or consoli-
illustrate the rules of paragraph (b)(1) of time of the transaction: all of the assets and liabili- dation for purposes of section 368(a)(1)(A).
ties of Z and U, the sole members of the transferor Example 7. Merger of a corporation into a dis-
this section. In each of the examples, ex- unit, become the assets and liabilities of one or more regarded entity in exchange for interests in the disre-
cept as otherwise provided, each of V, Y, members of the transferee unit that is comprised of Y, garded entity. (i) Under State W law, Z merges into
and Z is a C corporation. X is a limited li- the combining entity of the transferee unit, and X, a X. Pursuant to such law, the following events occur
ability company. Except as otherwise pro- disregarded entity the assets of which Y is treated as simultaneously at the effective time of the transac-
vided, X is wholly owned by Y and is dis- owning for Federal tax purposes, and Z ceases its sep- tion: all of the assets and liabilities of Z become the
arate legal existence for all purposes. Moreover, the assets and liabilities of X and Z’s separate legal exis-
regarded as an entity separate from Y for deemed transfer of the assets of U in exchange for U tence ceases for all purposes. In the merger of Z into
Federal tax purposes. The examples are as stock does not cause the transaction to fail to qualify X, the Z shareholders exchange their stock of Z for in-
follows: as a statutory merger or consolidation. See section terests in X so that, immediately after the merger, X is
Example 1. Divisive transaction pursuant to a 368(a)(2)(C). Accordingly, the transaction qualifies not disregarded as an entity separate from Y for Fed-
merger statute. (i) Under State W law, Z transfers as a statutory merger or consolidation for purposes of eral tax purposes. Following the merger, pursuant to
some of its assets and liabilities to Y, retains the re- section 368(a)(1)(A). §301.7701–3(b)(1)(i) of this chapter, X is classified
mainder of its assets and liabilities, and remains in Example 4. Triangular merger of a target corpo- as a partnership for Federal tax purposes.
existence following the transaction. The transaction ration into a disregarded entity. (i) The facts are the (ii) The transaction does not satisfy the require-
qualifies as a merger under State W corporate law. same as in Example 2, except that V owns 100 per- ments of paragraph (b)(1)(ii)(A) of this section
(ii) The transaction does not satisfy the require- cent of the outstanding stock of Y and, in the merger because immediately after the merger X is not
ments of paragraph (b)(1)(ii)(A) of this section be- of Z into X, the Z shareholders exchange their stock disregarded as an entity separate from Y and, con-
cause all of the assets and liabilities of Z, the com- of Z for stock of V. In the transaction, Z transfers sub- sequently, all of the assets and liabilities of Z, the
bining entity of the transferor unit, do not become the stantially all of its properties to X. combining entity of the transferor unit, do not become
assets and liabilities of Y, the combining entity and (ii) The transaction is not prevented from qualify- the assets and liabilities of one or more members of a
sole member of the transferee unit. In addition, the ing as a statutory merger or consolidation under sec- transferee unit. Accordingly, the transaction cannot
transaction does not satisfy the requirements of para- tion 368(a)(1)(A), provided the requirements of sec- qualify as a statutory merger or consolidation for
graph (b)(1)(ii)(B) of this section because the sepa- tion 368(a)(2)(D) are satisfied. Because the assets of purposes of section 368(a)(1)(A).
rate legal existence of Z does not cease for all pur- X are treated for Federal tax purposes as the assets of Example 8. Merger transaction preceded by dis-
poses. Accordingly, the transaction does not qualify Y, Y will be treated as acquiring substantially all of tribution. (i) Z operates two unrelated businesses,
as a statutory merger or consolidation under section the properties of Z in the merger for purposes of deter- Business P and Business Q, each of which represents
368(a)(1)(A). mining whether the merger satisfies the requirements 50 percent of the value of the assets of Z. Y desires to
Example 2. Merger of a target corporation into a of section 368(a)(2)(D). As a result, the Z sharehold- acquire and continue operating Business P, but does
disregarded entity in exchange for stock of the owner. ers that receive stock of V will be treated as receiving not want to acquire Business Q. Pursuant to a sin-
(i) Under State W law, Z merges into X. Pursuant to stock of a corporation that is in control of Y, the com- gle plan, Z sells Business Q for cash to parties unre-
such law, the following events occur simultaneously bining entity of the transferee unit that is the acquir- lated to Z and Y in a taxable transaction, and then dis-
at the effective time of the transaction: all of the as- ing corporation for purposes of section 368(a)(2)(D). tributes the proceeds of the sale pro rata to its share-
sets and liabilities of Z become the assets and liabil- Accordingly, the merger will satisfy the requirements holders. Then, pursuant to State W law, Z merges into
ities of X and Z’s separate legal existence ceases for of section 368(a)(2)(D). Y. Pursuant to such law, the following events occur si-
multaneously at the effective time of the transaction:

February 14, 2005 535 2005–7 I.R.B.


all of the assets and liabilities of Z related to Business Notice of Proposed Revenue Building, 1111 Constitution Av-
P become the assets and liabilities of Y and Z’s sep- enue, NW, Washington, DC.
arate legal existence ceases for all purposes. In the
Rulemaking
merger, the Z shareholders exchange their Z stock for FOR FURTHER INFORMATION
Y stock. Revision of Income Tax CONTACT: Concerning the pro-
(ii) The transaction satisfies the requirements of
paragraph (b)(1)(ii) of this section because the trans-
Regulations Under Sections posed regulations, Robert W. Lorence,
action is effected pursuant to State W law and the fol- 358, 367, and 884 Dealing Jr., (202) 622–3860; concerning submis-
lowing events occur simultaneously at the effective With Statutory Mergers or sions, the hearing, or placement on the
time of the transaction: all of the assets and liabil- building access list to attend the hear-
ities of Z, the combining entity and sole member of Consolidations Under Section
ing, Guy Traynor, (202) 622–7180 (not
the transferor unit, become the assets and liabilities of 368(a)(1)(A) Involving One or toll-free numbers).
Y, the combining entity and sole member of the trans-
feree unit, and Z ceases its separate legal existence for More Foreign Corporations
all purposes. Accordingly, the transaction qualifies SUPPLEMENTARY INFORMATION:
as a statutory merger or consolidation for purposes of REG–125628–01
section 368(a)(1)(A). Paperwork Reduction Act
Example 9. Transaction effected pursuant to for-
AGENCY: Internal Revenue Service
eign statutes. (i) Z and Y are entities organized under The collection of information contained
the laws of Country Q and classified as corporations (IRS), Treasury.
in this notice of proposed rulemaking has
for Federal tax purposes. Z and Y combine. Pursuant been submitted to the Office of Manage-
to statutes of Country Q the following events occur ACTION: Notice of proposed rulemaking.
simultaneously: all of the assets and liabilities of Z
ment and Budget for review in accordance
become the assets and liabilities of Y and Z’s sepa- SUMMARY: This document contains with the Paperwork Reduction Act (44
rate legal existence ceases for all purposes. proposed regulations amending the in- U.S.C. 3507(d)). Comments on the col-
(ii) The transaction satisfies the requirements of lection of information should be sent to the
paragraphs (b)(1)(ii) of this section because the trans-
come tax regulations under various pro-
visions of the Internal Revenue Code Office of Management and Budget, Attn:
action is effected pursuant to statutes of Country Q
and the following events occur simultaneously at the (Code) to account for statutory merg- Desk Officer for the Department of the
effective time of the transaction: all of the assets ers and consolidations under section Treasury, Office of Information and Reg-
and liabilities of Z, the combining entity of the trans- 368(a)(1)(A) (including reorganizations ulatory Affairs, Washington, DC 20503,
feror unit, become the assets and liabilities of Y, the with copies to the Internal Revenue Ser-
combining entity and sole member of the transferee
described in section 368(a)(2)(D) and (E))
involving one or more foreign corpora- vice, Attn: IRS Reports Clearance Officer,
unit, and Z ceases its separate legal existence for all
purposes. Accordingly, the transaction qualifies as a tions. These proposed regulations are SE:W:CAR:MP:T:T:SP, Washington, DC
statutory merger or consolidation for purposes of sec- issued concurrently with proposed reg- 20224. Comments on the collection of in-
tion 368(a)(1)(A). ulations (REG–117969–00) that would formation should be received no later than
(iv) Effective dates. This paragraph amend the definition of a reorganization March 7, 2005. Comments are specifically
(b)(1) applies to transactions occurring af- under section 368(a)(1)(A) to include cer- requested concerning:
ter the date these regulations are published tain statutory mergers or consolidations Whether the proposed collection of in-
as final regulations in the Federal Regis- effected pursuant to foreign law. formation is necessary for the proper per-
ter. For rules regarding statutory merg- formance of the functions of the IRS, in-
ers or consolidations on or after January DATES: Written and electronic com- cluding whether the information will have
24, 2003, and before these regulations are ments and requests to speak and outlines of practical utility;
published as final regulations in the Fed- topics to be discussed at the public hearing The accuracy of the estimated burden
eral Register, see §1.368–2T(b)(1). For scheduled for May 19, 2005, at 10:00 a.m. associated with the proposed collection of
rules regarding statutory mergers or con- must be received by April 28, 2005. information (see below);
solidations before January 24, 2003, see How the quality, utility, and clarity of
§1.368–2(b)(1) as it applies before January ADDRESSES: Send submissions to: the information to be collected may be en-
24, 2003 (see 26 CFR part 1, revised April CC:PA:LPD:PR (REG–125628–01), room hanced;
1, 2002). 5203, Internal Revenue Service, P.O. Box How the burden of complying with the
***** 7604, Ben Franklin Station, Washing- proposed collection of information can be
ton, DC 20044. Submissions may be minimized, including through the appli-
Mark E. Matthews, hand delivered Monday through Friday cation of automated collection techniques
Deputy Commissioner for between the hours of 8 a.m. and 4 p.m. or other forms of information technology;
Services and Enforcement. to: CC:PA:LPD:PR (REG–125628–01), and
Courier’s Desk, Internal Revenue Service, Estimates of capital or start-up costs
(Filed by the Office of the Federal Register on January 4,
2005, 8:45 a.m., and published in the issue of the Federal 1111 Constitution Avenue, NW, Wash- and costs of operation, maintenance, and
Register for January 5, 2005, 70 F.R. 746) ington, DC, or sent electronically, via the purchase of services to provide informa-
IRS Internet site at: www.irs.gov/regs tion.
or via the Federal eRulemaking Por- The collection of information
tal at www.regulations.gov (IRS and in this proposed regulation is in
REG–125628–01). The public hearing §1.367(a)–3(d)(2)(vi)(B)(1)(ii). This in-
will be held in the Auditorium, Internal formation is required to inform the IRS

2005–7 I.R.B. 536 February 14, 2005


of a domestic corporation that is claiming posed and temporary regulations define a that satisfies the ownership requirements
an exception from the application of sec- statutory merger or consolidation in a man- of section 1248(a) with respect to a foreign
tion 367(a) and (d) to certain transfers of ner intended to ensure that those transac- corporation. Section 1248(a) applies to a
property to a foreign corporation that is tions are not divisive in nature. Accord- U.S. person that owns stock (directly, in-
re-transferred by the foreign corporation ingly, the regulations generally require that directly, or constructively) with 10 percent
to a domestic corporation controlled by all the assets and liabilities of the merged or more of the voting power in the foreign
the foreign corporation. The information corporation (other than assets distributed corporation at any time during the 5-year
is in the form of a statement attached to the or liabilities discharged in the transaction) period ending on the sale or exchange of
domestic corporation’s U.S. income tax are transferred to the acquiring corporation the stock when the foreign corporation was
return for the year of the transfer certifying and that the separate legal identity of the a controlled foreign corporation (CFC).
that if the foreign corporation disposes of merged corporation ceases to exist in the Gain recognized by a section 1248 share-
the stock of the domestic controlled cor- transaction. holder on the sale or exchange of stock
poration with a tax avoidance purpose, the Pursuant to a notice of proposed rule- of the foreign corporation is included in
domestic corporation will file an income making (proposed section 368 regula- gross income as a dividend to the extent of
tax return (or amended return, as the case tions) published contemporaneously with the earnings and profits of the foreign cor-
may be) reporting gain. The collection this document, the IRS and Treasury are poration that are attributable to the stock
of information is mandatory. The likely proposing further revisions to the defini- sold or exchanged and that were accumu-
respondents are domestic corporations. tion of a statutory merger or consolidation lated while the stock was held by the U.S.
Estimated total annual reporting bur- to take into account those transactions person when the foreign corporation was
den: 50 hours. effected pursuant to foreign law. The pro- a CFC (the section 1248 amount).
Estimated average annual burden hours posed section 368 regulations amend the The IRS and Treasury believe that
per respondent: 1 hour. 2003 proposed regulations and provide it is important to preserve section 1248
Estimated number of respondents: 50. that an A reorganization may occur, if cer- amounts in certain nonrecognition ex-
Estimated annual frequency of re- tain conditions are satisfied, pursuant to changes of foreign corporation stock.
sponses: on occasion. the laws of a foreign jurisdiction, includ- Preservation of section 1248 amounts is a
An agency may not conduct or sponsor, ing a U.S. possession. function of the holding period and basis in
and a person is not required to respond to, a In light of this change, this document the stock of the foreign corporation being
collection of information unless it displays contains proposed amendments to the reg- exchanged. One of the underlying policies
a valid control number assigned by the Of- ulations under certain international Code of section 367(b) is the preservation of
fice of Management and Budget. provisions (sections 367, 884, and 6038B) the potential application of section 1248
Books or records relating to a collection to account for statutory mergers and con- in connection with certain nonrecognition
of information must be retained as long solidations involving one or more foreign exchanges. H. Rep. No. 94–658, 94th
as their contents may become material in corporations. Current international tax Cong., 1st Sess., at 242 (Nov. 12, 1975).
the administration of any internal revenue regulations are premised on an A reor- These proposed regulations provide ba-
law. Generally, tax returns and tax return ganization being limited to a statutory sis and holding period rules to preserve
information are confidential, as required merger or consolidation involving do- section 1248 amounts in the context of
by 26 U.S.C. 6103. mestic corporations effected pursuant to certain section 354 exchanges and certain
domestic law. See, e.g., Rev. Rul. 57–465, triangular reorganizations.
Background 1957–2 C.B. 250. As a result, conforming The basis and holding period rules of
changes must be made to these interna- the proposed regulations also apply to a
Section 368(a)(1)(A) defines a reorga- tional tax regulations to ensure that they foreign corporate shareholder of a foreign
nization to include a statutory merger apply appropriately to statutory mergers corporation that is a party to the reorgani-
or consolidation (A reorganization). and consolidations effected pursuant to zation, provided that the foreign corporate
For transactions completed before Jan- foreign law. The proposed regulations shareholder has at least one U.S. person
uary 24, 2003, regulations under section also modify the section 367(a) and (b) that is a section 1248 shareholder with re-
368(a)(1)(A) provided that a reorganiza- regulations to address several other related spect to the foreign corporate shareholder
tion was a merger or consolidation effected issues. and to the foreign corporation. This rule
pursuant to the corporation law of the is necessary to preserve application of sec-
United States or a State or Territory or the Explanation of Provisions tion 964(e) to the foreign corporate share-
District of Columbia. See §1.368–2(b)(1), holder with respect to lower-tier foreign
as in effect before January 24, 2003. A. Basis and Holding Period Rules corporations. Under section 964(e), if a
On January 24, 2003, the IRS and the CFC sells or exchanges stock in another
Treasury Department issued proposed reg- The proposed regulations provide basis foreign corporation, gain recognized on
ulations (REG–126485–01, 2003–1 C.B. and holding period rules for certain trans- the sale or exchange is included in the in-
542 [68 FR 3477]) and temporary regula- actions involving foreign corporations come of the CFC as a dividend to the same
tions (T.D. 9038, 2003–1 C.B. 524 [68 FR with section 1248 shareholders in order to extent that it would have been included
3384]), revising the definition of a statu- preserve relevant section 1248 amounts. A under section 1248(a) if the CFC were a
tory merger or consolidation. The pro- section 1248 shareholder is a U.S. person U.S. person. Such dividend income may

February 14, 2005 537 2005–7 I.R.B.


be treated as subpart F income that is in- 1248 shareholder, or a foreign corporate (a)(2)(D) (forward triangular merger) and
cluded in the income of U.S. shareholders shareholder where at least one U.S. person to parenthetical section 368(a)(1)(C) reor-
of the CFC. is a section 1248 shareholder with respect ganizations. In these transactions, the sur-
to such foreign corporate shareholder and viving corporation (S) acquires substan-
1. Section 354 exchanges to the foreign corporation whose shares are tially all the assets of the acquired corpora-
exchanged (collectively and individually, tion (T), and the T shareholders exchange
The proposed regulations apply to cer- section 367(b) shareholder), to ensure the their T stock for stock of the corporation
tain section 354 exchanges involving for- preservation of section 1248 amounts. The (P) that is in control (within the meaning
eign corporations, including exchanges of proposed regulations also include specific of section 368(c)) of S. These rules also
multiple blocks of stock. The proposed guidance on the shareholder’s holding pe- apply to reorganizations described in sec-
regulations preserve the bases and hold- riod in the stock received in the section tion 368(a)(1)(A) and (a)(2)(E) (reverse
ing periods in different blocks of stock in 354 exchange. The proposed regulations triangular merger). In a reverse triangu-
certain foreign target corporations by re- do not, however, apply to distributions de- lar merger, S, a controlled subsidiary of P,
quiring the exchanging shareholder to es- scribed in section 355. merges into T, the surviving corporation,
tablish the particular shares of stock that Consistent with the proposed section and the T shareholders exchange their T
were received in exchange for shares of 358 regulations, the proposed regulations stock for stock of P.
a particular block of target stock. If the hereunder would not apply to section 351 Under current regulations, in a forward
exchanging shareholder cannot establish exchanges or to exchanges to which both triangular merger or a parenthetical C re-
the particular shares of target stock that section 351 and section 354 (or section organization, P’s basis in its S stock is ad-
were received for shares of a particular 356) apply, if, in addition to stock being justed as if P had acquired the T assets di-
block of stock, then the shareholder must received, other property is received or lia- rectly from T in a section 362(b) exchange
designate which shares of stock were re- bilities are assumed. This limitation is in- and then had transferred the T assets to
ceived in exchange for shares of a par- tended to prevent a conflict between the S in a transaction in which P’s basis in
ticular block of stock, provided that the rules for determining basis in a section 351 S stock is determined under section 358.
designation is consistent with the terms of exchange (including the application of sec- See §1.358–6(c)(1) (commonly referred to
the exchange. These tracing methods are tion 357(c)) and the rules proposed in this as the “over-the-top” basis rules). Under
used to determine the resulting tax con- document. The IRS and Treasury are con- current regulations, in a reverse triangu-
sequences when stock received in a non- sidering approaches for the preservation of lar merger, P’s basis in the T stock it re-
recognition exchange is subsequently sold section 1248 amounts in section 351 trans- ceives immediately after the transaction is
or otherwise exchanged. If the exchanging actions in which liabilities are assumed or equal to its basis in its S stock immedi-
shareholder cannot establish, and does not other property is received, and comments ately before the transaction adjusted as if T
designate, the particular shares received, are requested in this regard. had merged into S in a forward triangular
the shareholder is treated as selling or oth- In addition, the IRS and Treasury are merger and the over-the-top basis rules had
erwise exchanging a share received in a considering developing specific rules for applied. See §1.358–6(c)(2). If a reverse
nonrecognition exchange for a share that situations in which stock of the foreign ac- triangular merger also qualifies as a section
was purchased or acquired at the earliest quiring corporation is not issued in the ex- 351 transfer or a section 368(a)(1)(B) reor-
time. change (for example, when the exchanging ganization, P can determine its basis in its
The IRS and Treasury recently pub- shareholder owns all the stock of the for- S stock either by using the over-the-top ba-
lished proposed section 358 regulations eign acquiring corporation). One possible sis rules as described in the prior sentence
(REG–116564–03, 2004–20 I.R.B. 927) approach may be for each existing share of or by treating P as if it had acquired the T
that determine the basis of stock or secu- stock in that corporation to be divided into stock from the former shareholders of T in
rities received in section 354 exchanges portions to account for the different basis a transaction in which basis is determined
(proposed section 358 regulations). The and holding periods of the stock of the for- under section 362(b) (carryover stock ba-
proposed section 358 regulations gener- eign acquiring corporation and the stock of sis).
ally provide that the basis of each share of the acquired corporation in order to pre- The IRS and Treasury are concerned
stock or security received in an exchange serve section 1248 amounts. Comments that, in certain exchanges involving for-
to which section 354, 355, or 356 applies are requested regarding this approach or eign corporations, application of the over-
will be the same as the basis of the share possible alternative approaches. the-top basis rules would not properly pre-
of stock or security exchanged therefor. serve the section 1248 or 964(e) amounts
For these purposes, the determination of 2. Triangular reorganizations with respect to the stock of S or T. The
which share of stock or security is received proposed regulations provide that, in de-
in exchange for a particular share of stock The proposed regulations provide spe- termining the stock basis of the surviving
or security is made in accordance with the cial basis and holding period rules for tri- corporation in certain triangular reorgani-
terms of the exchange or distribution. angular reorganizations where the merg- zations, outside stock basis will be used
These proposed regulations apply the ing or surviving corporation is a foreign instead of inside asset basis pursuant to
principles of the proposed section 358 reg- corporation with a section 367(b) share- §1.358–6(c). For example, in the case of
ulations to certain exchanges of stock of holder. These rules apply to reorganiza- a forward triangular merger (or a paren-
a foreign corporation by either a section tions described in section 368(a)(1)(A) and thetical C reorganization), where P is a do-

2005–7 I.R.B. 538 February 14, 2005


mestic corporation, S is a foreign corpo- period. Earnings and profits accumulated such shares are aggregated into a single
ration, T is a foreign corporation, and T prior to the reorganization are attributed divided portion for basis and holding pe-
has a section 1248 shareholder, the basis to a divided portion of a share of stock riod purposes.
and holding period in the T stock, not the based on the block of stock whose basis
T assets, are used to determine P’s basis and holding period the divided portion re- B. Exceptions to the Application of
in the S stock. The same rules apply to flects. Post-reorganization earnings and Section 367(a)
certain reverse triangular mergers, where profits are attributed to each divided share
S merges into T with T surviving. In that of stock pursuant to section 1248 and the Under section 367(a), a U.S. person rec-
case, P’s basis in the T stock immediately regulations thereunder. The amount of ognizes gain, but not loss, on the transfer
after the transaction would reflect the basis earnings and profits attributed to a divided of property to a foreign corporation in an
and holding period of the T stock instead of share of stock pursuant to section 1248 are exchange described in section 351, 354,
the T assets. further attributed to a divided portion of 356, or 361, unless an exception applies.
Under this stock basis approach for tri- such share of stock based on its fair market Section 367(a), however, does not apply
angular reorganizations, the proposed reg- value in relation to the other divided por- to a section 354 exchange by a U.S. per-
ulations provide for a divided basis and tions. Finally, shares of stock are no longer son of: (1) stock of a foreign corporation
holding period in each share of stock in divided into separate portions if section in a section 368(a)(1)(E) reorganization; or
the surviving corporation to reflect the rel- 1248 or 964(e) becomes inapplicable to a (2) stock of a domestic or foreign corpora-
evant section 1248 amounts in the S stock subsequent sale or exchange of the stock. tion for stock of a foreign corporation in
and T stock. In particular, each share of S The special basis rules in these pro- an asset reorganization described in sec-
stock in a forward triangular merger, and posed regulations apply to all triangular tion 368(a)(1)(C), (D), or (F) that is not
each share of T stock in a reverse trian- reorganizations where T has at least one treated as an indirect stock transfer under
gular merger, where P is a section 367(b) section 367(b) shareholder, even if such §1.367(a)–3(a).
shareholder immediately after the transac- shareholders own less than a controlling The proposed regulations amend
tion, is divided into portions reflecting the interest in T. The IRS and Treasury are §1.367(a)–3(a) so that this exception to the
basis and holding period of the S stock and considering whether the current basis rules application of section 367(a) also applies
the T stock before the transaction. How- of §1.358–6 should apply in cases where to A reorganizations (including forward
ever, the proposed regulations contain a de section 367(b) shareholders do not own a and reverse triangular mergers). In ad-
minimis exception to this rule. Under this substantial percentage of the stock of T, or dition, the proposed regulations clarify
exception, if the value of the S stock im- whether taxpayers should be permitted to that §1.367(a)–3(a) applies to exchanges
mediately before the transaction is de min- elect to apply the current basis rules un- described in section 356, as well as in
imis (for example, where S is a corpora- der §1.358–6 to determine P’s basis in the section 354. Section 356 applies to an ex-
tion formed to facilitate the transaction), stock of the surviving corporation (S or change that would qualify as a section 354
then each share of the surviving corpora- T), provided that all section 367(b) share- exchange except for the fact that money or
tion is not divided; instead, the basis of the holders of T include in income the section other property is received in the exchange.
S stock is added to the basis of the stock 1248 amounts with respect to the stock ex- Taxpayers have questioned why the ex-
of the surviving corporation held by P. The changed. Comments are requested in this ception to the application of section 367(a)
value of the S stock would be de minimis regard. in §1.367(a)–3(a) includes exchanges of
for this purpose if it is less than 1 percent The use of stock basis to determine stock but not exchanges of securities in
of the value of the surviving corporation (S P’s basis in the surviving corporation also section 368(a)(1)(E) reorganizations and
or T) immediately after the transaction. presents administrative concerns when a certain asset reorganizations. The IRS
If there are two or more blocks of stock portion of the stock of T is widely held. In and Treasury believe that it is appropri-
in T or S held by a section 367(b) share- the case of a reorganization described in ate to provide comparable treatment for
holder immediately before the transaction, section 368(a)(1)(B), which presents simi- exchanges of securities in this context. Ac-
then each share of the surviving corpora- lar issues, Rev. Proc. 81–70, 1981–2 C.B. cordingly, Notice 2005–6, 2005–5 I.R.B.
tion (S or T) is further divided to account 729, provides that statistical sampling 448), published contemporaneously with
for each block of stock. If two or more techniques, if appropriate, are permitted these proposed regulations, announces
blocks of stock are held by one or more to determine the basis of stock received that the IRS and Treasury intend to amend
shareholders that are not section 367(b) by the acquiring corporation. In this re- §1.367(a)–3(a) to apply the exception from
shareholders, then shares in these blocks gard, the IRS and Treasury recently have section 367(a) to exchanges of stock or
are aggregated into one divided portion requested comments whether Rev. Proc. securities. Notice 2005–6 applies to trans-
for basis purposes. If none of the S or 81–70 should be revised to reflect changes fers of securities after January 5, 2005.
T shareholders is a section 367(b) share- in the marketplace since its publication. Taxpayers also may apply the provisions
holder, then the over-the-top basis rules of See Notice 2004–44, 2004–28 I.R.B. 32. of the notice to transfers of securities oc-
§1.358–6 apply instead of the rules in these Comments are requested on expanding curring on or after July 20, 1998, and on
proposed regulations. this guidance to apply under the proposed or before January 5, 2005. In applying
The proposed regulations provide spe- regulations, for example in cases where this notice, however, taxpayers must do so
cial rules when stock of the surviving cor- blocks of T stock are held by persons that consistently to all transactions within its
poration has a divided basis and holding are not section 367(b) shareholders and scope.

February 14, 2005 539 2005–7 I.R.B.


The proposed regulations also provide cent or more (by vote or value) of the stock Questions with respect to the concur-
rules concerning the application of sec- of the foreign acquiring corporation or the rent application of section 367(a) and (b)
tion 367(a) to reverse triangular mergers, foreign parent immediately after the ex- have arisen in situations that otherwise
where stock of P, a corporation that con- change, the shareholder recognizes gain, if would require inclusion of the all earnings
trols the merging corporation S, is treated any, under section 367(a), unless the share- and profits amount under §1.367(b)–3.
as transferred (along with any other prop- holder enters into a gain recognition agree- If the all earnings and profits amount is
erty of S) to the surviving corporation T in ment as provided in §1.367(a)–8. If the greater than the section 367(a) gain with
a section 361 transfer. If S is a domestic exchanging shareholder is not a 5-percent respect to the stock of the foreign ac-
corporation and T is a foreign corporation, shareholder, then the exchanging share- quired corporation, under current law the
section 367(a) applies to the transfer by S holder does not recognize gain, if any, on exchanging shareholder effectively may
of the P stock to T, unless an exception ap- the exchange. elect to be taxed on the lesser amount of
plies. The U.S. shareholder’s exchange de- gain under section 367(a) simply by fail-
The IRS and Treasury believe that, if scribed above also may be subject to ing to file a gain recognition agreement. In
the stock of P is provided to S pursuant section 367(b). If the exchanging U.S. that case, section 367(b) would not apply
to the plan of reorganization, the section shareholder is a section 1248 shareholder and the shareholder would avoid inclusion
361 transfer of the P stock from S to T of the foreign acquired corporation, and in income of the greater all earnings and
should not be subject to section 367(a), and the stock of the foreign acquiring corpo- profits amount.
the proposed regulations so provide. If P ration (or its foreign parent corporation) The ability to elect to recognize the
does not provide its stock to S pursuant is not stock in a corporation that is a lesser gain inherent in the stock exchanged
to the plan of reorganization, then the P CFC as to which the U.S. shareholder is in such cases is inconsistent with the poli-
stock will be treated as property of S and a section 1248 shareholder immediately cies of section 367(b) that apply to inbound
the transfer of such stock will be subject to after the exchange, then the exchanging transactions, including preventing conver-
section 367(a). shareholder must include in income the sion of tax deferral into tax forgiveness and
The IRS and Treasury intend to amend section 1248 amount with respect to the ensuring that the domestic acquiring cor-
the regulations under section 6038B to stock exchanged. See §1.367(b)–4. If, poration’s section 381 carryover basis re-
conform with the changes made in these instead, a domestic acquiring corporation flects an after-tax amount. Accordingly,
regulations. acquires the assets of a foreign acquired the IRS and Treasury believe that the all
corporation, and the U.S. shareholder earnings and profits amount provisions un-
C. Concurrent Application of Section exchanges stock of the foreign acquired der §1.367(b)–3 should not operate elec-
367(a) and (b) corporation for stock of the foreign parent tively in these cases. The proposed regu-
of the acquiring corporation in a triangu- lations require that, for exchanges subject
The proposed regulations modify the
lar reorganization, then the exchanging to §1.367(b)–3 and section 367(a), section
current application of section 367(a) and
shareholder must include in income the all 367(b) would apply before section 367(a).
(b) to transactions that require the inclu-
earnings and profits amount with respect In that case, inclusion of the all earnings
sion in income of the all earnings and prof-
to the stock of the acquired corporation. and profits amount would increase the ex-
its amount under section 367(b). Sec-
See §1.367(b)–3. Unlike the section changing shareholder’s stock basis for pur-
tion 1.367(a)–3(b)(2) provides rules for the
1248 amount, the all earnings and profits poses of computing the shareholder’s gain
concurrent application of section 367(a)
amount is not limited by the shareholder’s under section 367(a). Thus, if the all earn-
and (b) to transfers of stock of a foreign
gain inherent in the stock of the foreign ings and profits amount exceeds the inher-
corporation. This may occur, for exam-
acquired corporation. ent gain in the exchanged stock, gain is
ple, when a U.S. shareholder exchanges
In cases where section 367(a) and (b) not recognized under section 367(a). If the
stock of a foreign corporation (foreign ac-
apply concurrently to a transaction, exist- transaction does not involve inclusion of
quired corporation) for stock of another
ing §1.367(a)–3(b)(2) provides that sec- the all earnings and profits amount (for ex-
foreign corporation (foreign acquiring cor-
tion 367(b) will not apply if the transfer is ample, if §1.367(b)–4 applies), the exist-
poration). See §1.367(a)–3(b)(1). It may
taxable under section 367(a). If the trans- ing ordering rules continue to apply.
also occur when an acquiring corporation
fer is taxable under section 367(a), the ex-
(foreign or domestic) acquires the assets D. Parenthetical Section 368(a)(1)(B)
changing U.S. shareholder will recognize
of a foreign acquired corporation, and the Reorganizations
gain inherent in the exchanged stock (sub-
U.S. shareholder exchanges stock of the
ject to recharacterization as dividend in-
foreign acquired corporation for stock of In a parenthetical reorganization under
come under section 1248). If the transfer is
the foreign parent of the acquiring corpo- section 368(a)(1)(B), if a U.S. shareholder
not taxable under section 367(a), because
ration in a triangular reorganization. exchanges stock of an acquired corpora-
the exchanging U.S. shareholder either is
The U.S. person’s exchange of stock of tion for voting stock of a foreign corpo-
not a 5-percent shareholder or enters into
the foreign acquired corporation for stock ration that controls (within the meaning
a gain recognition agreement, then section
of either the foreign acquiring corporation of section 368(c)) the acquiring corpo-
367(b) applies and the exchange is subject
or the foreign parent is subject to section ration, the U.S. shareholder is treated as
to either §1.367(b)–3 or 1.367(b)–4 at the
367(a). See §1.367(a)–3(b) and (d). If the making an indirect transfer of stock of the
shareholder level.
exchanging U.S. shareholder owns 5 per- acquired corporation to the foreign con-

2005–7 I.R.B. 540 February 14, 2005


trolling corporation in a transfer subject to part of the assets or stock acquired in the that is subject to the §1.367(a)–3(b) stock
section 367(a). See §1.367(a)–3(d)(1)(iii). transaction are transferred to a corporation transfer rules. If the acquired corpora-
This result occurs even if the acquiring controlled by the acquiring corporation. tion is domestic, the U.S. shareholder is
corporation is domestic. If the U.S. share- On August 16, 2004, the IRS and Trea- treated as transferring stock of a domestic
holder owns five percent or more (by vote sury issued proposed regulations under corporation to the foreign acquiring cor-
or value) of the stock of the foreign con- §1.368–2(k) that permit assets or stock poration in a transaction that is subject to
trolling corporation, the shareholder must acquired in any reorganization under §1.367(a)–3(c). This deemed transfer of
recognize gain inherent in the exchanged section 368(a)(1) to be transferred to a domestic stock prevails even if the con-
stock, unless a gain recognition agreement corporation controlled by the acquiring trolled subsidiary is foreign. Similar rules
is filed. A gain recognition agreement corporation without disqualifying the re- apply to parenthetical C reorganizations.
filed with respect to the transfer may be organization. Prior to these proposed Some commentators have suggested
triggered (and gain on the initial transfer regulations, the IRS and Treasury issued that the determination of whether domes-
of stock will be recognized) if the for- Rev. Rul. 2002–85, 2002–2 C.B. 986, tic or foreign stock is deemed transferred
eign controlling corporation disposes of which extended this treatment to sec- should be based on the status of the con-
the stock of the acquiring corporation, tion 368(a)(1)(D) reorganizations. Notice trolled subsidiary, rather than the status
or the acquiring corporation disposes of 2002–77, 2002–2 C.B. 997, issued con- of the acquired corporation. Under this
the stock of the acquired corporation, temporaneously with Rev. Rul. 2002–85, approach, if the acquired corporation were
within 5 years of the initial transfer. See provided that §1.367(a)–3(d)(1)(v) would domestic and the controlled subsidiary
§1.367(a)–3(d)(2)(ii). be amended to treat transactions described were foreign, the U.S. shareholders would
The proposed regulations revise the in- in Rev. Rul. 2002–85 as indirect stock be deemed to transfer foreign corporation
direct stock transfer rules to include trian- transfers, if the transfer of assets by the stock subject to §1.367(a)–3(b), rather
gular section 368(a)(1)(B) reorganizations acquiring corporation to its controlled than domestic corporation stock subject to
in which a U.S. shareholder exchanges subsidiary occurred pursuant to the plan §1.367(a)–3(c). The IRS and Treasury be-
stock of the acquired corporation for vot- of reorganization. lieve that, consistent with the framework
ing stock of a domestic corporation that The effect of the proposed regulations of the current regulations, it is appropriate
controls a foreign acquiring corporation. under §1.368–2(k) is to permit transfers of for the rules to continue to apply based on
In such a case, the gain recognition agree- assets or stock to a controlled subsidiary in the stock that is owned and exchanged by
ment may be triggered if the domestic con- reorganizations not specifically identified the U.S. person in the transaction (rather
trolling corporation disposes of the stock or mentioned in section 368(a)(2)(C) (sec- than on the stock of the controlled sub-
of the foreign acquiring corporation, or tion 368(a)(1)(D) and (F) reorganizations). sidiary). The IRS and Treasury are consid-
the foreign acquiring corporation disposes The proposed regulations amend the indi- ering the application of §§1.367(a)–3(b),
of the stock of the acquired corporation, rect stock transfer rules to conform to the 1.367(a)–3(c), and 1.367(a)–8 to situations
within 5 years of the initial transfer. changes in the section 368 regulations. As where the foreign acquiring corporation
a result, the proposed regulations provide transfers assets of the acquired corpora-
E. Transfers of Assets Following Certain that the transfer of assets to a controlled tion to multiple controlled subsidiaries
Asset Reorganizations subsidiary subsequent to an asset reorgani- (including both domestic and foreign sub-
zation under section 368(a)(1) would con- sidiaries), comments are requested in this
If a U.S. shareholder exchanges stock
stitute an indirect transfer of stock, pro- regard.
or securities of an acquired corporation
vided the transfer of assets by the foreign
for stock or securities of a foreign ac- G. Coordination of the Indirect Stock
acquiring corporation to its controlled sub-
quiring corporation in a reorganization Transfer Rules and the Asset Transfer
sidiary occurs as part of the same transac-
described in section 368(a)(1)(C), and the Rules
tion.
foreign acquiring corporation transfers all
or part of the assets of the acquired cor- F. Indirect Transfers Involving a Change In the case of an indirect stock transfer
poration to a subsidiary controlled (within in Domestic or Foreign Status of Acquired that also involves a transfer of assets by a
the meaning of section 368(c)) by the Corporation domestic corporation to a foreign corpora-
foreign acquiring corporation in a trans- tion, §1.367(a)–3(d)(2)(vi) generally pro-
action described in section 368(a)(2)(C), As indicated above, under existing vides that section 367(a) and (d) apply to
the U.S. shareholder is treated, for pur- §1.367(a)–3(d)(1)(v), a U.S. shareholder the transfer of assets prior to application
poses of section 367(a), as transferring the of an acquired corporation is treated as of the indirect stock transfer rules. How-
stock of the acquired corporation to the transferring the stock of the acquired cor- ever, section 367(a) does not apply to such
foreign acquiring corporation to the extent poration to the foreign acquiring corpora- transfers to the extent that the foreign ac-
of the assets transferred to the controlled tion to the extent of the assets transferred quiring corporation transfers the assets re-
subsidiary. §1.367(a)–3(d)(1)(v). Section to the controlled subsidiary. Thus, if the ceived in the asset transfer to a domestic
368(a)(2)(C) provides that a transaction acquired corporation is foreign, the U.S. corporation controlled (within the mean-
otherwise qualifying as a reorganization shareholder is treated as transferring stock ing of section 368(c)) by the foreign ac-
under section 368(a)(1)(A), (B), (C), and of a foreign corporation to the foreign quiring corporation in a transfer described
(G) will not be disqualified because all or acquiring corporation in a transaction in section 368(a)(2)(C) or in a transfer de-

February 14, 2005 541 2005–7 I.R.B.


scribed in section 351, provided the do- (described below) to its tax return for the however, the basis of the re-transferred
mestic transferee’s basis in the assets is no taxable year of the transfer. assets held by the domestic controlled
greater than the basis that the domestic ac- The statement that the domestic ac- corporation will not be increased by such
quired corporation had in such assets. The quired corporation files must certify that, if gain. Finally, the anti-abuse provision
initial asset transfer to the foreign corpora- the foreign acquiring corporation disposes under §1.367(d)–1T(g)(6) will not ap-
tion is not subject to section 367(a) in such of any stock of the domestic controlled ply to intangible property included in the
cases because the assets re-transferred to corporation with a principal purpose of re-transferred assets.
the domestic corporation remain subject to avoiding U.S. tax that would have been
U.S. corporate tax. imposed on the domestic acquired corpo- H. Application of Section 367(b)
The IRS and Treasury are concerned ration had it disposed of the re-transferred Regulations to Certain Triangular
that asset reorganizations subject to this assets, the domestic acquired corporation Reorganizations
coordination rule may be used to facilitate will amend its return for the year of the
corporate inversion transactions. An in- initial transaction and recognize gain (de- Section 367(b) applies to exchanges un-
version generally involves a U.S. multina- scribed below). The disposition of stock der sections 332, 351, 354, 355, 356, and
tional corporation reincorporating outside is presumed to have a principal purpose 361 (except to the extent described in sec-
the United States for tax purposes (either of tax avoidance if the disposition occurs tion 367(a)(1)) in which the status of a for-
as a foreign corporation or as a subsidiary within 2 years of the transfer. The pre- eign corporation as a corporation for tax
of a new foreign corporation). The IRS sumption may be rebutted, however, if the purposes is necessary for application of the
and Treasury also are concerned that the domestic acquired corporation (or the for- relevant nonrecognition provisions. Ex-
coordination rule might be used to facil- eign acquiring corporation on its behalf) cept as provided in regulations, under sec-
itate divisive transactions. The proposed demonstrates to the satisfaction of the tion 367(b) a foreign corporation that is a
regulations address both of these concerns Commissioner that the transaction did not party to such an exchange is considered
by modifying the scope of the coordination have a principal purpose of tax avoidance. to be a corporation for tax purposes, and
rule. If the domestic acquired corporation therefore the parties involved in the trans-
The revised coordination rule operates recognizes gain pursuant to the statement, action are eligible for nonrecognition treat-
as follows. Section 367(a) and (d) gener- it is treated as if, immediately prior to the ment.
ally apply to the transfer of assets to a for- exchange, it had transferred the re-trans- Section 1.367(b)–4 applies to acquisi-
eign corporation even if the foreign cor- ferred assets, including any intangible tions by a foreign corporation (the foreign
poration transfers all or part of the assets assets, directly to a domestic corporation acquiring corporation) of the stock or as-
received to a controlled domestic corpora- in exchange for stock of the corporation in sets of another foreign corporation (the for-
tion. This general rule, however, is subject a transaction that is treated as a section 351 eign acquired corporation) in certain non-
to two exceptions which do not require in- exchange, and immediately sold the stock recognition exchanges (a section 367(b)
come recognition under section 367(a) and to an unrelated party at fair market value exchange). Consistent with section 1248,
(d) on the transfer of assets to the foreign in a sale in which it recognizes gain, if §1.367(b)–4(b)(1)(i) addresses exchanges
corporation to the extent that assets are any, but not loss. For purposes of this rule, by a section 1248 shareholder (or, in cer-
re-transferred to the domestic controlled the deemed transfer to a domestic corpo- tain cases, a CFC shareholder that has a
corporation. ration is treated as a section 351 exchange section 1248 shareholder), and generally
The first exception applies if the do- regardless of whether all the requirements requires such a shareholder to include in
mestic acquired corporation is controlled for nonrecognition under section 351 are income its section 1248 amount as a re-
(within the meaning of section 368(c)) by 5 otherwise satisfied. Treating the domes- sult of a section 367(b) exchange, if im-
or fewer domestic corporations, appropri- tic acquired corporation as recognizing mediately after the exchange (i) the stock
ate basis adjustments as provided in sec- gain on the disposition of stock, rather received in the exchange is not stock in
tion 367(a)(5) are made to the stock of than assets, is intended to approximate the a corporation that is a controlled foreign
the foreign acquiring corporation, and any consequences that would have resulted corporation as to which the section 1248
other conditions provided in regulations had the domestic acquired corporation shareholder described above is a section
under section 367(a)(5) are satisfied. Al- transferred the assets to a corporation 1248 shareholder, or (ii) the foreign ac-
though there currently are no regulations and sold the stock received in such trans- quiring corporation or the foreign acquired
under section 367(a)(5), this exception will fer prior to the outbound reorganization. corporation (if any, such as in a transac-
incorporate any conditions or limitations In addition, this treatment is consistent tion described in section 368(a)(1)(B) or
in future regulations once published. with other provisions that address divisive 351), is not a controlled foreign corpora-
In cases where the first exception does transactions. See, e.g., section 355(e) and tion as to which the section 1248 share-
not apply, the second exception applies if §1.367(e)-(2)(b)(2)(iii). holder described above is a section 1248
the following two conditions are satisfied: The basis that the foreign acquiring shareholder.
(1) the indirect transfer of stock of the do- corporation has in the stock of the do- Therefore, in a triangular reorganiza-
mestic acquired corporation satisfies the mestic controlled corporation is increased tion (such as a triangular reorganization
requirements of §1.367(a)–3(c)(1)(i), (ii), by the amount of gain recognized by the described in section 368(a)(1)(C)) that is
and (iv), and (c)(6); and (2) the domestic domestic acquired corporation under these within the scope of §1.367(b)–4, a section
acquired corporation attaches a statement rules immediately prior to its disposition; 367(b) shareholder must include in income

2005–7 I.R.B. 542 February 14, 2005


the section 1248 amount if, for example, in this regard. The IRS and Treasury organizations and welcome comments on
it receives stock of a domestic corporation also are considering, and request com- revisions that are necessary in this regard,
in exchange for its stock in a controlled ments, on situations in which there are as well as comments on other issues under
foreign corporation. This is the case be- multiple shareholders (including minority these regulations.
cause, immediately after the exchange, the shareholders) of the domestic corporation;
section 367(b) shareholder does not hold multiple assets (including appreciated and Proposed Effective Date
stock in a corporation that is a controlled depreciated assets being transferred as part
Except as otherwise specified, these
foreign corporation as to which such share- of the section 361 transfer); and liabili-
regulations are proposed to apply to trans-
holder is a section 367(b) shareholder. ties being assumed in connection with the
actions occurring after the date these reg-
Pursuant to the basis rules con- transaction.
ulations are published as final regulations
tained in this proposed regulation under
J. Nonrecognition Transactions under the in the Federal Register.
§1.367(b)–13, the section 1248 amount
with respect to the stock of the foreign FIRPTA and PFIC Provisions
Special Analyses
acquired corporation that is exchanged
Section 897(a) generally treats gain or
can be properly preserved in the stock of The IRS and the Treasury Department
loss from the disposition of a U.S. real
a foreign corporation owned by a domes- have determined that this notice of pro-
property interest by a nonresident alien
tic corporation when the section 367(b) posed rulemaking is not a significant regu-
individual or a foreign corporation as
shareholder receives stock of the domestic latory action as defined in Executive Or-
gain or loss that is effectively connected
corporation in a triangular reorganization. der 12866. Therefore, a regulatory as-
with the conduct of a trade or business
Consequently, the proposed regulations sessment pursuant to that Order is not re-
within the United States. Sections 897(d)
provide that a section 367(b) shareholder quired. It has also been determined that
and (e) provide rules that apply section
receiving stock of a domestic corporation section 553(b) of the Administrative Pro-
897 in the context of distributions and
in a triangular reorganization is not re- cedure Act (5 U.S.C. chapter 5) does not
nonrecognition exchanges of U.S. real
quired to include in income the section apply to these regulations, and that because
property interests. Temporary regulations
1248 amount under §1.367(b)–4(b)(1)(i), this regulation does not impose a collec-
were issued under sections 897(d) and
provided that the domestic corporation, tion of information on small entities, the
(e) providing guidance on the applica-
immediately after the exchange, is a sec- Regulatory Flexibility Act (5 U.S.C. chap-
tion of section 897 to certain corporate
tion 1248 shareholder of the surviving ter 6) does not apply. Pursuant to section
transactions involving U.S. real property
corporation (or in the case of a parenthet- 7805(f) of the Code, this regulation will be
interests. See §1.897–5T, 1.897–6T, and
ical section 368(a)(1)(B) reorganization, submitted to the Chief Counsel for Advo-
Notice 89–85, 1989–2 C.B. 403. These
of the acquired corporation) that is itself a cacy of the Small Business Administration
rules do not specifically address A reor-
controlled foreign corporation. for comment on its impact on small busi-
ganizations because such regulations were
ness.
I. Application of Section 367(b) based on A reorganizations being limited
Regulations to Certain Outbound to statutory mergers between domestic Comments and Public Hearing
Reorganizations corporations. The IRS and Treasury in-
tend to revise these regulations to reflect Before these proposed regulations are
If a domestic corporation is a section A reorganizations and welcome comments adopted as final regulations, consideration
1248 shareholder with respect to a foreign on revisions that are necessary to apply will be given to any written comments
corporation and transfers the stock in such these regulations to A reorganizations, as (a signed original and eight (8) copies)
foreign corporation to another foreign cor- well as comments on other issues under or electronic comments that are submitted
poration in a section 361 transfer, the do- the regulations. timely to the IRS. The IRS and Treasury
mestic corporation must include in income Section 1291(f) provides authority to Department specifically request comments
the section 1248 amount, if any, with re- issue regulations concerning the exchange on the clarity of the proposed regulations
spect to the stock of the transferred for- of stock in a passive foreign investment and on how they can be made easier to un-
eign corporation. See section 1248(f)(1) company (PFIC) in a nonrecognition derstand. All comments will be available
and §1.367(b)–4(b)(2)(ii), Example 4. transaction. Proposed regulations were for public inspection and copying.
Taxpayers have commented that this published in the Federal Register (57 A public hearing has been scheduled for
rule may result in income inclusions in FR 11047) on April 1, 1992, providing May 19, 2005, beginning at 10:00 a.m. in
some cases where the section 1248 amount rules for the disposition of PFIC stock the Auditorium, Internal Revenue Build-
could be preserved, such that a current in- by U.S. shareholders in nonrecognition ing, 1111 Constitution Avenue, NW, Wash-
clusion may not be necessary or appropri- exchanges. See §1.1291–6 of the pro- ington, DC. Due to building security pro-
ate. The IRS and Treasury are considering posed regulations. The application of cedures, visitors must enter at the Consti-
the application of section 367(a)(5) and these proposed regulations is based on A tution Avenue entrance. In addition, all
section 1248(f)(1) to such transactions, in reorganizations being limited to statutory visitors must present photo identification
conjunction with §1.367(b)–13 of these mergers between domestic corporations. to enter the building. Because of access
regulations, to preserve section 1248 The IRS and Treasury intend to revise restrictions, visitors will not be admitted
amounts, and comments are requested these proposed regulations to reflect A re- beyond the immediate entrance area more

February 14, 2005 543 2005–7 I.R.B.


than 30 minutes before the hearing starts. PART 1—INCOME TAXES 4. In paragraph (d)(1), introductory
For information about having your name text, first sentence, add the parenthetical
placed on the building access list to attend Paragraph 1. The authority citation for “(or in a domestic corporation in control
the hearing, see the FOR FURTHER IN- part 1 continues to read, in part, as follows: of a foreign acquiring corporation in a tri-
FORMATION CONTACT portion of this Authority: 26 U.S.C. 7805 * * * angular section 368(a)(1)(B) reorganiza-
preamble. Par. 2. In section 1.358–1, paragraph tion)” after the words “for stock or secu-
The rules of 26 CFR 601.601(a)(3) ap- (a) is amended by adding a sentence at the rities in a foreign corporation”.
ply to the hearing. Persons who wish to end of the paragraph to read as follows: 5. In paragraph (d)(1), introductory
present oral comments must submit writ- text, remove the last sentence and add three
ten or electronic comments and an out- §1.358–1 Basis to distributees. sentences in its place.
line of the topics to be discussed and the 6. In paragraph (d)(1)(i), remove the
(a) * * * In the case of certain section
time to be devoted to each topic (a signed last sentence and add a sentence in its
354 or 356 exchanges of stock in a foreign
original and eight (8) copies) by April 28, place.
corporation, §1.367(b)–13 applies instead
2005. A period of 10 minutes will be 7. In paragraph (d)(1)(ii), add a sen-
of the rules of §1.358–2.
allotted to each person for making com- tence at the end of the paragraph.
ments. An agenda showing the scheduling ***** 8. Paragraph (d)(1)(iii) is revised.
of the speakers will be prepared after the Par. 3. In §1.358–6, paragraph (e) is 9. In paragraph (d)(1)(iv), remove the
deadline for receiving outlines has passed. amended by adding a sentence at the end language “Example 7” and add “Example
Copies of the agenda will be available free of the paragraph to read as follows: 8” in its place, and remove “Example 11”
of charge at the hearing. and add “Example 14” in its place.
§1.358–6 Stock basis in certain triangular 10. Revise paragraph (d)(1)(v).
Drafting Information reorganizations. 11. Revise paragraphs (d)(2)(i) and
(ii).
The principal author of these regula- ***** 12. In paragraph (d)(2)(iv), last sen-
tions is Robert W. Lorence, Jr., of the Of- (e) * * * For certain triangular reorga- tence, remove the language “Example 4”
fice of Associate Chief Counsel (Interna- nizations where the surviving corporation and add “Examples 5 and 5A” in its place.
tional). However, other personnel from (S or T) is foreign, see §1.367(b)–13. 13. Revise paragraph (d)(2)(v)(C).
the IRS and Treasury Department partic-
***** 14. Redesignate paragraph (d)(2)(v)
ipated in their development.
Par. 4. Section 1.367(a)–3 is amended (D) as paragraph (d)(2)(v)(F).
***** 15. Add new paragraphs (d)(2)(v)(D)
as follows:
1. In paragraph (a), remove the third and (E).
Proposed Amendments to the
and fourth sentences, and add five sen- 16. Revise paragraph (d)(2)(vi).
Regulations
tences in their place. 17. In paragraph (d)(3), redesignate the
Accordingly, 26 CFR part 1 is proposed 2. Revise paragraph (b)(2)(i). examples as follows and add the following
to be amended as follows: 3. Revise paragraph (c)(5)(vi). new examples:

Redesignate As Add
Example 12 Example 16
Example 15
Examples 11 and 11A Examples 14 and 14A
Examples 10 and 10A Examples 13 and 13A
Example 9 Example 12
Examples 10 and 11
Example 8 Example 9
Examples 7, 7A, 7B, and 7C Examples 8, 8A, 8B, and 8C
Examples 6 and 6A Examples 7 and 7A
Examples 5, 5A, and 5B Examples 6, 6A, and 6B
Examples 6C and 6D
Example 4 Example 5
Example 5A

2005–7 I.R.B. 544 February 14, 2005


Redesignate As Add
Example 3 Example 4
Example 2 Example 3
Example 2

18. In paragraph (d)(3), newly desig- 19. In paragraph (d)(3), newly desig- the first column, replace the language in
nated Example 6A, paragraph (i), the first nated Example 6B and Example 9 are re- the second column with the language in the
and last sentences are revised. vised. third column:
20. In paragraph (d)(3), for each of
the newly designated examples listed in

Redesignated Examples Remove Add


Example 6A, paragraph (i), first sentence Example 5 Example 6
Example 7, paragraph (i) Example 5 Example 6
Example 7A, paragraph (i) and paragraph Example 6 Example 7
(ii), penultimate sentence
Example 8, paragraph (i) Example 5 Example 6
Example 8A, paragraph (i) Example 7 Example 8
Example 8B, paragraph (i) Example 7 Example 8
Example 8C, paragraph (i) Example 7 Example 8
Example 12, paragraph (i), third sentence Example 9 Example 12
Example 13A, paragraph (i) and paragraph Example 10 Example 13
(ii), first sentence
Example 14A, paragraph (i) Example 11 Example 14

22. In paragraph (e)(1), remove the 368(a)(1) involving a transfer of assets un- (i) In general. A transfer of foreign
first sentence and add two sentences in its der section 361. If, in a transfer described stock or securities described in section
place. in section 361, a domestic merging corpo- 367(a) and the regulations thereunder as
The revisions and additions are as fol- ration transfers stock of a controlling cor- well as in section 367(b) and the regula-
lows: poration to a foreign surviving corporation tions thereunder shall be subject concur-
in a reorganization described in sections rently to sections 367(a) and (b) and the
§1.367(a)–3 Treatment of transfers of 368(a)(1)(A) and (a)(2)(E), such section regulations thereunder, except as provided
stock or securities to foreign corporations. 361 transfer is not subject to section 367(a) in paragraph (b)(2)(i)(A) or (B) of this
if the stock of the controlling corporation section. See paragraph (d)(3), Example
***** is provided to the merging corporation by 11, of this section.
(a) * * * However, if, in an exchange the controlling corporation pursuant to the (A) If a foreign corporation transfers as-
described in section 354 or 356, a U.S. plan of reorganization; a section 361 trans- sets to a domestic corporation in a transac-
person exchanges stock of a foreign cor- fer of other property, including stock of tion to which §1.367(b)–3(a) and (b) and
poration in a reorganization described in the controlling corporation not provided the indirect stock transfer rules of para-
section 368(a)(1)(E), or a U.S. person ex- by the controlling corporation pursuant to graph (d) of this section apply, then the sec-
changes stock of a domestic or foreign cor- the plan of reorganization, by the domestic tion 367(b) rules shall apply prior to the
poration for stock of a foreign corporation merging corporation to the foreign surviv- section 367(a) rules. See paragraph (d)(3),
pursuant to an asset reorganization that is ing corporation pursuant to such a reorga- Example 15, of this section. This para-
not treated as an indirect stock transfer un- nization is subject to section 367(a). For graph (b)(2)(i)(A) applies only to transac-
der paragraph (d) of this section, such sec- special basis and holding period rules in- tions occurring after the date these regula-
tion 354 or 356 exchange is not a trans- volving foreign corporations that are par- tions are published as final regulations in
fer to a foreign corporation subject to sec- ties to certain reorganizations under sec- the Federal Register.
tion 367(a). See paragraph (d)(3), Exam- tion 368(a)(1), see §1.367(b)–13.* * * (B) Except as provided in paragraph
ple 16, of this section. For purposes of this (b) * * * (b)(2)(i)(A) of this section, section 367(b)
section, an asset reorganization is defined (2) * * * and the regulations thereunder shall not ap-
as a reorganization described in section ply if the foreign corporation is not treated

February 14, 2005 545 2005–7 I.R.B.


as a corporation under section 367(a)(1). (B) A U.S. person exchanges stock of reorganization (other than a triangular
See paragraph (d)(3), Example 14, of this the acquired corporation for voting stock section 368(a)(1)(C) reorganization de-
section. of a domestic corporation that is in control scribed in paragraph (d)(1)(iv) of this
***** (as defined in section 368(c)) of a foreign section or a reorganization described in
(c) * * * acquiring corporation in a reorganization sections 368(a)(1)(A) and (a)(2)(D) or
(5) * * * described in section 368(a)(1)(B). (a)(2)(E) described in paragraphs (d)(1)(i)
(vi) Transferee foreign corpora- (1) For purposes of paragraphs (b) and or (ii) of this section) that is followed by
tion. Except as provided in paragraph (c) of this section, the foreign acquiring a controlled asset transfer. In the case of
(d)(1)(iii)(B) of this section, the transferee corporation is considered to be the trans- a transaction described in this paragraph
foreign corporation shall be the foreign feree foreign corporation even though the (d)(1)(v) in which some but not all of
corporation that issues stock or securities U.S. transferor receives stock of the do- the assets of the acquired corporation are
to the U.S. person in the exchange. mestic controlling corporation in the ex- transferred in a controlled asset transfer,
change. the transaction shall be considered to be
***** (2) If stock of a foreign acquired cor- an indirect transfer of stock or securities
(d) * * * poration is exchanged for the voting stock subject to this paragraph (d) only to the
(1) * * * For examples of the concur- of a domestic corporation in control of a extent of the assets so transferred. The
rent application of the indirect stock trans- foreign acquiring corporation, then the ex- remaining assets shall be treated as having
fer rules under section 367(a) and the rules change will be subject to the rules of para- been transferred in an asset transfer rather
of section 367(b), see paragraph (d)(3), Ex- graph (b) of this section. If the exchang- than an indirect stock transfer, and such
amples 14 and 15 of this section. For ing shareholder is a section 1248 share- asset transfer shall be subject to the other
purposes of this paragraph (d), if a cor- holder with respect to the foreign acquired provisions of section 367, including sec-
poration acquiring assets in a reorganiza- corporation, the indirect transfer will be tions 367(a)(1), (3), and (5), and (d) if the
tion described in section 368(a)(1) trans- subject to sections 367(a) and (b) con- acquired corporation is a domestic corpo-
fers all or a portion of such assets to a cor- currently. For the application of section ration. See paragraph (d)(3), Examples
poration controlled (within the meaning of 367(b) to the exchange, see §§1.367(b)–4 6A and 6B of this section.
section 368(c)) by the acquiring corpora- and 1.367(b)–13(c).
tion as part of the same transaction, the (3) If stock of a domestic acquired cor- *****
subsequent transfer of assets to the con- poration is exchanged for the voting stock (2) * * *
trolled corporation will be referred to as of a domestic corporation in control of a (i) Transferee foreign corporation. Ex-
a controlled asset transfer. See section foreign acquiring corporation, then the ex- cept as provided in paragraph (d)(1)(iii)(B)
368(a)(2)(C). change will be subject to the rules of para- of this section, the transferee foreign cor-
(i) * * * See paragraph (d)(3), Ex- graph (c) of this section. poration shall be the foreign corporation
ample 1 of this section for an example (4) For purposes of applying the that issues stock or securities to the U.S.
of a reorganization described in sections gain recognition agreement provisions person in the exchange.
368(a)(1)(A) and (a)(2)(D) involving of paragraph (d)(2) of this section and (ii) Transferred corporation. The
domestic acquired and acquiring corpora- §1.367(a)–8, the domestic controlling cor- transferred corporation shall be the ac-
tions, and see paragraph (d)(3), Example poration will be treated as the transferee quiring corporation, except as provided in
10 of this section for an example involv- foreign corporation. Thus, a disposition this paragraph (d)(2)(ii). In the case of a
ing a domestic acquired corporation and a of foreign acquiring corporation stock by triangular section 368(a)(1)(B) reorgani-
foreign acquiring corporation. the domestic controlling corporation, or a zation described in paragraph (d)(1)(iii)
(ii) * * * See paragraph (d)(3), Ex- disposition of acquired corporation stock of this section, the transferred corpora-
ample 2 of this section for an example by the foreign acquiring corporation, tion shall be the acquired corporation. In
of a reorganization described in sections will trigger the gain recognition agree- the case of an indirect stock transfer de-
368(a)(1)(A) and (a)(2)(E) involving do- ment. See paragraph (d)(3), Example 5A scribed in paragraph (d)(1)(i), (ii), or (iv)
mestic acquired and acquiring corpora- of this section. of this section followed by a controlled
tions, and see paragraph (d)(3), Example (5) This paragraph (d)(1)(iii)(B) ap- asset transfer, or an indirect stock transfer
11 of this section for an example involv- plies only to transactions occurring after described in paragraph (d)(1)(v) of this
ing a domestic acquired corporation and a the date these regulations are published section, the transferred corporation shall
foreign acquiring corporation. as final regulations in the Federal Regis- be the controlled corporation to which
(iii) Triangular reorganizations de- ter. the assets are transferred. In the case of
scribed in section 368(a)(1)(B)—(A) A successive section 351 transfers described
U.S. person exchanges stock of the ac- ***** in paragraph (d)(1)(vi) of this section, the
quired corporation for voting stock of a (v) Transfers of assets to subsidiaries transferred corporation shall be the corpo-
foreign corporation that is in control (as in certain section 368(a)(1) reorganiza- ration to which the assets are transferred
defined in section 368(c)) of the acquiring tions. A U.S. person exchanges stock or in the final section 351 transfer. The
corporation in a reorganization described securities of a corporation (the acquired transferred property shall be the stock or
in section 368(a)(1)(B). See paragraph corporation) for stock or securities of a securities of the transferred corporation,
(d)(3), Example 5 of this section. foreign acquiring corporation in an asset as appropriate under the circumstances.

2005–7 I.R.B. 546 February 14, 2005


***** (i) The domestic acquired corpora- case may be) for the year of the transfer re-
(v) * * * tion is controlled (within the meaning of porting such gain.
(C) In the case of an asset reorganiza- section 368(c)) by 5 or fewer domestic (D) Gain recognition transaction . (1)
tion followed by a controlled asset transfer, corporations, appropriate basis adjust- A transaction described in this paragraph
as described in paragraph (d)(1)(v) of this ments as provided in section 367(a)(5) are (d)(2)(vi)(D) is one where a principal pur-
section, the assets of the acquired corpora- made to the stock of the foreign acquir- pose of the transfer by the domestic ac-
tion that are transferred to the corporation ing corporation, and any other conditions quired corporation is the avoidance of U.S.
controlled by the acquiring corporation; as provided in regulations under section tax that would have been imposed on the
(D) In the case of a triangular reorga- 367(a)(5) are satisfied. For purposes of domestic acquired corporation on the dis-
nization described in section 368(a)(1)(C) determining whether the domestic ac- position of the re-transferred assets. A
followed by a controlled asset transfer, quired corporation is controlled by 5 or transfer may have a principal purpose of
or a reorganization described in sections fewer domestic corporations, all members tax avoidance even though the tax avoid-
368(a)(1)(A) and (a)(2)(D) followed by of the same affiliated group within the ance purpose is outweighed by other pur-
a controlled asset transfer, the assets of meaning of section 1504 shall be treated poses when taken together.
the acquired corporation including those as 1 corporation. (2) For purposes of paragraph
transferred to the corporation controlled (ii) The requirements of paragraphs (d)(2)(vi)(D)(1) of this section, a transac-
by the acquiring corporation; (c)(1)(i), (ii), and (iv), and (c)(6) of this tion is deemed to have a principal purpose
(E) In the case of a reorganization section are satisfied with respect to the of tax avoidance if the foreign acquiring
described in sections 368(a)(1)(A) and indirect transfer of stock in the domestic corporation disposes of any stock of the
(a)(2)(E) followed by a controlled asset acquired corporation, and the domestic domestic controlled corporation (whether
transfer, the assets of the acquiring corpo- acquired corporation attaches a statement in a recognition or non-recognition trans-
ration including those transferred to the described in paragraph (d)(2)(vi)(C) of action) within 2 years of the transfer. The
corporation controlled by the acquiring this section to its U.S. income tax return rule in this paragraph (d)(2)(vi)(D)(2) shall
corporation; and for the taxable year of the transfer. not apply if the domestic acquired corpora-
***** (2) Sections 367(a) and (d) shall not tion (or the foreign acquiring corporation
(vi) Coordination between asset trans- apply to transfers described in paragraph on behalf of the domestic acquired corpo-
fer rules and indirect stock transfer (d)(1)(vi) of this section where a U.S. per- ration) demonstrates to the satisfaction of
rules—(A) General rule. If, pursuant son transfers assets to a foreign corpora- the Commissioner that the avoidance of
to any of the transactions described in tion in a section 351 exchange, to the ex- U.S. tax was not a principal purpose of the
paragraph (d)(1) of this section, a U.S. tent that such assets are transferred by such transaction.
person transfers (or is deemed to transfer) foreign corporation to a domestic corpora- (E) Amount of gain recognized and
assets to a foreign corporation in an ex- tion in another section 351 exchange, but other matters. (1) In the case of a transac-
change described in section 351 or 361, only if the domestic transferee’s basis in tion described in paragraph (d)(2)(vi)(D)
the rules of section 367, including sections the assets is no greater than the basis that of this section, solely for purposes of this
367(a)(1), (a)(3), and (a)(5), as well as the U.S. transferor had in such assets. paragraph (d)(2)(vi)(E), the domestic ac-
section 367(d), and the regulations there- (C) Required statement. The statement quired corporation shall be treated as if,
under shall apply prior to the application required by paragraph (d)(2)(vi)(B)(1)(ii) immediately prior to the transfer, it trans-
of the rules of this section. of this section shall be entitled “Required ferred the re-transferred assets, including
(B) Exceptions. (1) If a transaction Statement under §1.367(a)–3(d) for As- any intangible assets, directly to a domes-
is described in paragraph (d)(2)(vi)(A) of sets Transferred to a Domestic Corpora- tic corporation in exchange for stock of
this section, sections 367(a) and (d) shall tion” and shall be signed under penalties such domestic corporation in a transaction
not apply to the extent a domestic cor- of perjury by an authorized officer of the that is treated as a section 351 exchange,
poration (domestic acquired corporation) domestic acquired corporation and by an and immediately sold such stock to an un-
transfers its assets to a foreign corporation authorized officer of the foreign acquir- related party for its fair market value in a
(foreign acquiring corporation) in an asset ing corporation. The required statement sale in which it shall recognize gain, if any
reorganization, and such assets (re-trans- shall contain a certification that, if the for- (but not loss). Any gain recognized by the
ferred assets) are transferred to a domes- eign acquiring corporation disposes of any domestic acquired corporation pursuant to
tic corporation (domestic controlled cor- stock of the domestic controlled corpora- this paragraph (d)(2)(vi)(E) will increase
poration) controlled (within the meaning tion in a transaction described in paragraph the basis that the foreign acquiring cor-
of section 368(c)) by the foreign acquiring (d)(2)(vi)(D) of this section, the domestic poration has in the stock of the domestic
corporation as part of the same transaction, acquired corporation shall recognize gain controlled corporation immediately before
provided that the domestic controlled cor- as described in paragraph (d)(2)(vi)(E)(1) the transaction described in paragraph
poration’s basis in such assets is no greater of this section. The domestic acquired cor- (d)(2)(vi)(D) of this section, but will not
than the basis that the domestic acquired poration (or the foreign acquiring corpo- increase the basis of the re-transferred
corporation had in such assets and the con- ration on behalf of the domestic acquired assets held by the domestic controlled cor-
ditions contained in either of the following corporation) shall file a U.S. income tax re- poration. Section 1.367(d)–1T(g)(6) shall
paragraphs are satisfied: turn (or an amended U.S. tax return, as the not apply with respect to any intangible

February 14, 2005 547 2005–7 I.R.B.


property included in the re-transferred as- ments of paragraph (c)(1)(i) and (ii) of this section, satisfies the test set forth in paragraph (c)(3) of this
sets described in the preceding sentence. U’s indirect ownership of S stock (through its direct section.
(2) If additional tax is required to be ownership of F stock) will determine whether the re- (ii) Result. The transfer of the Business A as-
quirement of paragraph (c)(1)(i) is satisfied and will sets is not affected by the rules of this paragraph (d).
paid as a result of a transaction described be taken into account in determining whether the re- However, the transfer of such assets is subject to gain
in paragraph (d)(2)(vi)(D) of this section, quirement of paragraph (c)(1)(ii) is satisfied. See recognition under section 367(a)(1), because the sec-
then interest must be paid on that amount paragraph (c)(4)(iv)). For purposes of applying the tion 367(a)(3) active trade or business exception is
at rates determined under section 6621 gain recognition agreement provisions of paragraph inapplicable pursuant to section 367(a)(5). The Busi-
with respect to the period between the date (d)(2) of this section and §1.367(a)–8, F is treated as ness B and C assets are part of an indirect stock trans-
the transferee foreign corporation. The gain recogni- fer under this paragraph (d) but must first be tested
prescribed for filing the domestic acquired tion agreement would be triggered if F sold all or a under sections 367(a) and (d). The transfer of the
corporation’s income tax return for the portion of the stock of S, or if S sold all or a portion Business B assets (which otherwise would satisfy the
year of the transfer and the date on which of the stock of Y. section 367(a)(3) active trade or business exception)
the additional tax for that year is paid. generally is subject to section 367(a)(1) pursuant to
*****
(F) Examples. For illustrations of the section 367(a)(5). The transfer of the Business C as-
Example 6A. Section 368(a)(1)(C) reorganization
sets generally is subject to sections 367(a)(1) and (d).
rules in paragraph (d)(2)(vi) of this sec- followed by a controlled asset transfer—(i) Facts.
However, pursuant to paragraph (d)(2)(vi)(B) of this
tion, see paragraph (d)(3), Examples 6B, The facts are the same as in Example 6, except that
section, the transfer of the Business B and C assets is
the transaction is structured as a section 368(a)(1)(C)
6C, 6D, 9, and 13A of this section. not subject to sections 367(a)(1) and (d), provided the
reorganization, followed by a controlled asset trans-
(G) Effective dates. Paragraph (d)(2) basis of the Business B and C assets in the hands of R
fer, and R is a foreign corporation. * * * F then con-
(vi) of this section applies only to trans- is no greater than the basis in the hands of Z and cer-
tributes Businesses B and C to R in a controlled asset
tain other requirements are satisfied. Since Z is not
actions occurring after the date these transfer. * * *
controlled within the meaning of section 368(c) by
regulations are published as final reg- ***** 5 or fewer domestic corporations, the indirect trans-
ulations in the Federal Register. See Example 6B. Section 368(a)(1)(C) reorganization fer of Z stock must satisfy the requirements of para-
§1.367(a)–3(d)(2)(vi), as contained in 26 followed by a controlled asset transfer to a domestic graphs (c)(1)(i), (ii), and (iv), and (c)(6) of this sec-
CFR Part 1 revised as of April 1, 2004, controlled corporation—(i) Facts. The facts are the tion, and Z must attach a statement described in para-
same as in Example 6A, except that R is a domestic graph (d)(2)(vi)(C) of this section to its U.S. income
for transactions occurring on or after July corporation. tax return for the taxable year of the transfer. In gen-
20, 1998, until the date these regulations (ii) Result. As in Example 6A, the outbound trans- eral, the statement must contain a certification that,
are published as final regulations in the fer of the Business A assets to F is not affected by if F disposes of the stock of R (in a recognition or
Federal Register. the rules of this paragraph (d) and is subject to the nonrecognition transaction) and a principal purpose
(3) * * * general rules under section 367. However, the Busi- of the transfer is the avoidance of U.S. tax that would
ness A assets qualify for the section 367(a)(3) active have been imposed on Z on the disposition of the
Example 2. Section 368(a)(1)(A)/(a)(2)(E) re-
trade or business exception. The Business B and C Business B and C assets transferred to R, then Z (or F
organization—(i) Facts. The facts are the same as
in Example 1, except that Newco merges into W and assets are part of an indirect stock transfer under this on behalf of Z) will file a return (or amended return as
paragraph (d) but must first be tested under sections the case may be) recognizing gain ($50), as if, imme-
Newco receives stock of W which it distributes to F
367(a) and (d). The Business B assets qualify for diately prior to the reorganization, Z transferred the
in a reorganization described in sections 368(a)(1)(A)
and (a)(2)(E). Pursuant to the reorganization, A re- the active trade or business exception under section Business B and C assets to a domestic corporation in
367(a)(3); the Business C assets do not. However, exchange for stock in a transaction treated as a section
ceives 40 percent of the stock of F in an exchange
pursuant to paragraph (d)(2)(vi)(B) of this section, the 351 exchange and immediately sold such stock to an
described in section 354.
(ii) Result. The consequences of the transfer are Business C assets are not subject to section 367(a) or unrelated party for its fair market value. A transac-
(d), provided that the basis of the Business C assets in tion is deemed to have a principal purpose of U.S. tax
similar to those described in Example 1. Pursuant
the hands of R is no greater than the basis of the assets avoidance if F disposes of R stock within two years of
to paragraph (d)(1)(ii) of this section, the reorganiza-
tion is subject to the indirect stock transfer rules. F in the hands of Z, and appropriate basis adjustments the transfer, unless Z (or F on behalf of Z) can rebut
are made pursuant to section 367(a)(5) to the stock the presumption to the satisfaction of the Commis-
is treated as the transferee foreign corporation, and
of F held by V. (In this case, no adjustments are re- sioner. See paragraph (d)(2)(vi)(D)(2) of this section.
W is treated as the transferred corporation. Provided
that the requirements of paragraph (c)(1) of this sec- quired because, pursuant to section 358, V takes a ba- With respect to the indirect transfer of Z stock, the
sis of $30 in the stock of F, which is equal to V’s pro- requirements of paragraphs (c)(1)(i), (ii), and (iv) of
tion are satisfied, including the requirement that A
portionate share of the basis in the assets of Z ($30) this section are satisfied. Thus, assuming Z attaches
enter into a five-year gain recognition agreement as
described in §1.367(a)–8, A’s exchange of W stock transferred to F.) V also is deemed to make an indi- the statement described in paragraph (d)(2)(vi)(C) of
rect transfer of stock under the rules of paragraph (d). this section to its U.S. income tax return and satisfies
for F stock under section 354 will not be subject to
To preserve non-recognition treatment under section the reporting requirements of (c)(6) of this section,
section 367(a)(1).
367(a), V must enter into a 5-year gain recognition the transfer of Business B and C assets is not subject
***** agreement in the amount of $50, the amount of the ap- to section 367(a) or (d).
Example 5A. Triangular section 368(a)(1)(B) re- preciation in the Business B and C assets, as the trans- Example 6D. Section 368(a)(1)(C) reorgani-
organization—(i) Facts. The facts are the same as fer of such assets by Z was not taxable under section zation followed by a controlled asset transfer to a
in Example 5, except that F is a domestic corporation 367(a)(1) and constituted an indirect stock transfer. domestic controlled corporation—(i) Facts. The
and S is a foreign corporation. Example 6C. Section 368(a)(1)(C) reorganization facts are the same as in Example 6C, except that the
(ii) Result. U’s exchange of Y stock for stock of followed by a controlled asset transfer to a domestic Z shareholders receive 60 percent of the F stock in
F, a domestic corporation in control of S, the foreign controlled corporation—(i) Facts. The facts are the exchange for their Z stock in the reorganization.
acquiring corporation, is treated as an indirect transfer same as in Example 6B, except that Z is owned by in- (ii) Result. The requirement of paragraph (c)(1)(i)
of Y stock to a foreign corporation under paragraph dividuals, none of whom qualify as five-percent tar- of this section is not satisfied because the Z share-
(d)(1)(iii) of this section. U’s exchange of Y stock get shareholders with respect to Z within the meaning holders that are U.S. persons do not receive 50
for F stock will not be subject to section 367(a)(1) of paragraph (c)(5)(iii) of this section. The following percent or less of the total voting power and the
provided that all of the requirements of paragraph additional facts are present. No U.S. persons that are total value of the stock of F in the transaction. Ac-
(c)(1) are satisfied, including the requirement that U either officers or directors of Z own any stock of F cordingly, Z shareholders that are U.S. persons are
enter in a five-year gain recognition agreement. In immediately after the transfer. F is engaged in an ac- subject to section 367(a)(1) on their exchange of
satisfying the 50 percent or less ownership require- tive trade or business outside the United States that Z stock for F stock pursuant to the reorganization.

2005–7 I.R.B. 548 February 14, 2005


For the same reason, the conditions of paragraph on the transfer of Business A assets to R. Because (ii) Result. Because a domestic corporation,
(d)(2)(vi)(B)(1)(ii) of this section are not met. Ac- V and Z file a consolidated return, V’s basis in the Newco, acquires the assets of a foreign corpo-
cordingly, the transfer of Business B and C assets is stock of Z is increased from $100 to $140 as a result ration, FC, in an asset reorganization to which
subject to sections 367(a)(1) and (d), even though of Z’s $40 gain. V’s indirect transfer of Z stock will §1.367(b)–3(a) and (b) and the indirect stock rules
such assets are re-transferred to R, a domestic corpo- be taxable under section 367(a) unless V enters into of paragraph (d) of this section apply, the section
ration. As in Example 6C, the transfer of Business A a gain recognition agreement in the amount of $60 367(b) rules apply before the section 367(a) rules
assets, which is not affected by the rules of paragraph ($200 value of Z stock less $140 adjusted basis) and apply. See §1.367(a)–3(b)(2)(i)(A). Under the rules
(d) of this section, is subject to gain recognition the other requirements of paragraph (c)(1) of this sec- of section 367(b), P must include in income the all
under sections 367(a)(1) and (5). tion are satisfied. earnings and profits amount of $60 with respect
Example 11. Section 368(a)(1)(A)/(a)(2)(E) re- to its FC stock. See §1.367(b)–3. Although P’s
*****
organization—(i) Facts. F, a foreign corporation, exchange of FC stock for F stock under section 354
Example 9. Concurrent application with a con-
trolled asset transfer—(i) Facts. The facts are the owns all the stock of D, a domestic corporation. V, a is an indirect stock transfer, no gain is recognized
domestic corporation, owns all the stock of Z, a for- under section 367(a), because P’s basis in the FC
same as in Example 8, except that R transfers the
eign corporation. V has a basis of $100 in the stock stock is increased by the amount ($60) included
Business A assets to M, a wholly owned domestic
subsidiary of R, in a controlled asset transfer. In ad- of Z which has a fair market value of $200. D is in income under the rules of section 367(b). See
an operating corporation with assets valued at $100 §1.367(b)–2(e)(3)(ii). Alternatively, if P’s all earn-
dition, V’s basis in its Z stock is $90.
with a basis of $60. In a reorganization described in ings and profits amount were $30, then the amount
(ii) Result. Pursuant to paragraph (d)(2)(vi)(B) of
this section, sections 367(a) and (d) do not apply to sections 368(a)(1)(A) and (a)(2)(E), D merges into Z, of the income inclusion and basis adjustment under
and V exchanges its Z stock for 55 percent of the out- the rules of section 367(b) would be $30, and the
Z’s transfer of the Business A assets to R, because
standing F stock. amount of gain subject to section 367(a)(1) would be
such assets are re-transferred to M, a domestic corpo-
ration, provided that the basis of the Business A as- (ii) Result. Under paragraph (d)(1)(ii) of this $20 unless P entered into a 5-year gain recognition
section, V is treated as making an indirect transfer agreement in accordance with §1.367(a)–8.
sets in the hands of M is no greater than the basis of
of Z stock to F. V’s exchange of Z stock for F stock
the assets in the hands of Z, and certain other require-
will be taxable under section 367(a) (and section * * * * *
ments are satisfied. Because Z is controlled (within
the meaning of section 368(c)) by V, a domestic cor-
1248 will be applicable) if V fails to enter into a (e) * * *
5-year gain recognition agreement in accordance (1) In general. Except as provided in
poration, appropriate basis adjustments must be made
with the requirements of §1.367(a)–8. Under para-
pursuant to section 367(a)(5) to the stock of F held by paragraphs (b)(2)(i)(A), (d)(1)(iii)(B), and
graph (b)(2) of this section, if V enters into a gain
V. (In this case, no adjustments are required because, (d)(2)(vi)(G), or in this paragraph (e), the
recognition agreement, the exchange will be subject
pursuant to section 358, V takes a basis of $90 in the
to the provisions of section 367(b) and the regula- rules in paragraphs (a), (b), and (d) of this
stock of F, which is less than V’s proportionate share
of the basis in the assets of Z ($100) transferred to R.)
tions thereunder as well as section 367(a). Under section apply to transfers occurring on or
§1.367(b)–4(b) of this chapter, however, no income after July 20, 1998. The rules in para-
Section 367(a)(1) does not apply to Z’s transfer of its
inclusion is required because both F and Z are con-
Business B assets to R (which are not re-transferred graphs (a) and (d) of this section, as they
trolled foreign corporations with respect to which
to M) because such assets qualify for an exception apply to section 368(a)(1)(A) reorganiza-
V is a section 1248 shareholder immediately after
to gain recognition under section 367(a)(3). With re-
the exchange. Under paragraphs (d)(2)(i) and (ii) of tions (including reorganizations described
spect to the indirect transfer of Z stock, such trans-
fer is not subject to gain recognition under section
this section, the transferee foreign corporation is F, in section 368(a)(2)(D) or (E)) involving
and the transferred corporation is Z (the acquiring a foreign acquiring or acquired corpora-
367(a)(1) if the requirements of paragraph (c) of this
corporation). If F disposes (within the meaning of
section are satisfied, including the requirement that tion, apply only to transfers occurring af-
§1.367(a)–8(e)) of all (or a portion) of Z stock within
V enter into a 5-year gain recognition agreement and ter the date these regulations are published
the 5-year term of the agreement (and V has not
comply with the requirements of §1.367(a)–8 with re-
made a valid election under §1.367(a)–8(b)(1)(vii)), as final regulations in the Federal Regis-
spect to the gain ($100) realized on the Z stock. Un-
der paragraphs (d)(2)(i) and (ii) of this section, the
V is required to file an amended return for the year ter. * * *
of the transfer and include in income, with interest,
transferee foreign corporation is F and the transferred
corporation is M. Pursuant to paragraph (d)(2)(iv) of the gain realized but not recognized on the initial *****
section 354 exchange. To determine whether Z (the Par. 5. Section 1.367(a)–8 is amended
this section, a disposition by F of the stock of R, or
transferred corporation) disposes of substantially
a disposition by R of the stock of M, will trigger the as follows:
gain recognition agreement. To determine whether an all of its assets, the assets of Z immediately prior
to the transaction are taken into account, pursuant
1. In paragraphs (c)(2) and (d), remove
asset disposition constitutes a deemed disposition of
to paragraph (d)(2)(v)(B) of this section. Because the words “district director” and add “Di-
the transferred corporation’s stock under the rules of
§1.367(a)–8(e)(3)(i), both the Business A assets in M D is owned by F, a foreign corporation, section rector of Field Operations” in their place.
367(a)(5) precludes any assets of D from qualifying 2. In paragraph (e)(1)(i), a sentence is
and the Business B assets in R must be considered.
for nonrecognition under section 367(a)(3). Thus, D
Example 10. Concurrent application in sec- added after the first sentence.
tion 368(a)(1)(A)/(a)(2)(D) reorganization—(i) recognizes $40 of gain on the transfer of its assets to
Z under section 367(a)(1).
The addition reads as follows:
Facts. The facts are the same as in Example 8,
except that R acquires all of the assets of Z in a *****
§1.367(a)–8 Gain recognition agreement
reorganization described in sections 368(a)(1)(A) Example 15. Concurrent application of indirect
and (a)(2)(D). Pursuant to the reorganization, V stock transfer rules and section 367(b)— (i) Facts. F, requirements.
receives 30 percent of the stock of F in a section 354 a foreign corporation, owns all of the stock of Newco,
exchange. a domestic corporation. P, a domestic corporation, *****
(ii) Result. The consequences of the transaction owns all of the stock of FC, a foreign corporation. P’s (e) * * *
are similar to those in Example 8. The assets of Busi- basis in the stock of FC is $50 and the value of FC (1) * * *
nesses A and B that are transferred to R must be tested stock is $100. The all earnings and profits amount
(i) * * * It also includes an in-
under section 367(a) prior to the consideration of the with respect to the FC stock held by P is $60. See
indirect stock transfer rules of this paragraph (d). The §1.367(b)–2(d). In a reorganization described in direct disposition of the stock of the
Business B assets qualify for the active trade or busi- sections 368(a)(1)(A) and (a)(2)(D) (and paragraph transferred corporation as described in
ness exception under section 367(a)(3). Because the (d)(1)(i) of this section), Newco acquires all of the §1.367(a)–3(d)(2)(iv). * * *
Business A assets do not qualify for the exception, properties of FC, and P exchanges its stock in FC for
Z must recognize $40 of gain under section 367(a) 20 percent of the stock in F. *****

February 14, 2005 549 2005–7 I.R.B.


Par. 6. In §1.367(b)–1(a), remove the assets of a foreign corporation (the foreign immediately after the reorganization, then paragraph
third and fourth sentences and add a sen- acquired corporation) in an exchange de- (b)(1)(i) of this section does not apply to require
tence in their place to read as follows: scribed in section 351 or a reorganization inclusion in income of the section 1248 amount
and the amount of the gain recognition agreement
described in section 368(a)(1). In the case is the amount of gain realized on the indirect stock
§1.367(b)–1 Other transfers. of a reorganization described in sections transfer. If FP or FC2 is not a controlled foreign
368(a)(1)(A) and (a)(2)(E), this section ap- corporation as to which DC is a (direct or indirect)
(a) * * * For rules coordinating the con- plies if stock of the foreign surviving cor- section 1248 shareholder immediately after the ex-
current application of sections 367(a) and poration is exchanged for stock of a for- change, then DC must include in income the section
(b), including the extent to which section 1248 amount ($20) attributable to the FC2 stock that
eign corporation in control of the merging DC exchanged. Under these circumstances, the gain
367(b) does not apply if the foreign corpo- corporation; in such a case, the foreign sur- recognition agreement would be the amount of gain
ration is not treated as a corporation under viving corporation is treated as a foreign realized on the indirect transfer, less the $20 section
section 367(a), see §1.367(a)–3(b)(2)(i). acquired corporation for purposes of this 1248 income inclusion.
*** section. A foreign corporation that under- Example 3B. (i) Facts. The facts are the same as
Example 3, except that USP, a domestic corporation,
***** goes a reorganization described in section owns the controlling interest (within the meaning of
Par. 7. In §1.367(b)–3(b)(3)(ii), revise 368(a)(1)(E) is treated as both the foreign section 368(c)) in FC1 stock. FC2 merges into FC1
paragraph (i) of Example 5 to read as fol- acquired corporation and foreign acquir- in a reorganization described in sections 368(a)(1)(A)
ing corporation for purposes of this sec- and (a)(2)(D). Pursuant to the reorganization, DC
lows:
tion. See §1.367(a)–3(b)(2) for transac- exchanges its FC2 stock for USP stock.
(ii) Result. Because DC receives stock of a do-
§1.367(b)–3 Repatriation of foreign tions subject to the concurrent application mestic corporation, USP, in the section 354 exchange,
corporate assets in certain nonrecognition of this section and section 367(a). the transfer is not an indirect stock transfer subject
transactions. (b) * * * to section 367(a). Accordingly, the exchange will
(1) * * * be subject only to the provisions of section 367(b)
***** (ii) Exception. In the case of a trian- and the regulations thereunder. Under paragraph
(b)(1)(ii)(A) of this section, because the stock re-
(b) * * * gular reorganization described in section ceived is stock of a domestic corporation (USP) and,
(3) * * * 368(a)(1)(B) or (C), or a reorganization immediately after the exchange, USP is a section
(ii) * * * described in sections 368(a)(1)(A) and 1248 shareholder of FC1 (the acquiring corporation)
Example 5—(i) Facts. DC1, a domestic corpo- (a)(2)(D) or (E), an exchange is not de- and FC1 is a controlled foreign corporation, the
ration, owns all of the outstanding stock of FC1, a exchange is not described in paragraph (b)(1)(i) of
scribed in paragraph (b)(1)(i) of this sec-
foreign corporation. FC1 owns all of the outstand- this section and DC includes no amount in its gross
ing stock of FC2, a foreign corporation. The all earn- tion if the stock received in the exchange income. See §1.367(b)–13(b) and (c) for the basis
ings and profits amount with respect to the FC2 stock is stock of a domestic corporation and, and holding period rules applicable to this transac-
owned by FC1 is $20. In a reorganization described immediately after the exchange, such do- tion, which cause USP’s adjusted basis and holding
in section 368(a)(1)(A), DC2, a domestic corporation mestic corporation is a section 1248 share- period in the stock of FC1 after the transaction to
unrelated to FC1 or FC2, acquires all of the assets reflect the basis and holding period that DC had in
holder of the acquired corporation (in the
and liabilities of FC2 pursuant to a State W merger. its FC2 stock.
FC2 receives DC2 stock and distributes such stock to case of a triangular section 368(a)(1)(B)
FC1. The FC2 stock held by FC1 is canceled, and reorganization) or the surviving corpo- *****
FC2 ceases its separate legal existence. ration (in the case of a reorganization Par. 9. In §1.367(b)–6, paragraph
described in sections 368(a)(1)(A) and (a)(1), add a sentence to the end to read as
*****
(a)(2)(D) or (E)) and such acquired or sur- follows:
Par. 8. Section 1.367(b)–4 is amended
viving corporation is a controlled foreign
as follows.
corporation. See paragraph (b)(1)(iii) of §1.367(b)–6 Effective dates and
1. Paragraph (a) is revised.
this section, Example 3B for an illustration coordination rules.
2. Redesignate paragraph (b)(1)(ii) as
of this rule.
paragraph (b)(1)(iii), and add new para-
(iii) * * * (a) * * *
graph (b)(1)(ii). Example 3A. (i) Facts. The facts are the same
3. In newly designated paragraph as in Example 3, except that FC1 merges into FC2
(1) * * * The rules of §§1.367(b)–3 and
(b)(1)(iii), after Example 3, add Examples in a reorganization described in sections 368(a)(1)(A) 1.367(b)–4, as they apply to reorganiza-
3A and 3B. and (a)(2)(E). Pursuant to the reorganization, DC ex- tions described in section 368(a)(1)(A) (in-
The revisions and additions read as fol- changes its FC2 stock for stock of FP. cluding reorganizations described in sec-
(ii) Result. The result is similar to the result in
lows: tion 368(a)(2)(D) or (E)) involving a for-
Example 3. The transfer is an indirect stock transfer
subject to section 367(a). See §1.367(a)–3(d)(1)(ii).
eign acquiring or foreign acquired corpo-
§1.367(b)–4 Acquisition of foreign Accordingly, DC’s exchange of FC2 stock for FP ration, apply only to transfers occurring af-
corporate stock or assets by a foreign stock will be taxable under section 367(a) (and sec- ter the date these regulations are published
corporation in certain nonrecognition tion 1248 will be applicable) if DC fails to enter into a as final regulations in the Federal Regis-
transactions. gain recognition agreement. If DC enters into a gain
ter.
recognition agreement, the exchange will be subject
to the provisions of section 367(b) and the regula-
(a) Scope. This section applies to an ac- tions thereunder, as well as section 367(a). If FP and
*****
quisition by a foreign corporation (the for- FC2 are controlled foreign corporations as to which Par. 10. Section 1.367(b)–13 is added
eign acquiring corporation) of the stock or DC is a (direct or indirect) section 1248 shareholder to read as follows:

2005–7 I.R.B. 550 February 14, 2005


§1.367(b)–13 Special rules for (C) T is a corporation that is another ular share or shares of stock (or portion of
determining basis and holding period. party to the reorganization. a share of stock) is received in exchange
(b) Determination of basis and holding for a particular share or shares of stock, the
(a) Scope and definitions—(1) Scope. period for exchanges of foreign stock—(1) shareholder may designate which share or
This section provides special basis and Application. Except as provided in para- shares of stock is received in exchange for
holding period rules for certain transac- graph (b)(4) of this section, this paragraph a particular share or shares of stock, pro-
tions involving the acquisition of property (b) applies to a shareholder that exchanges vided that such designation is consistent
by a foreign acquiring corporation in stock of a foreign acquired corporation in with the terms of the exchange or distribu-
nonrecognition exchanges. Special rules an exchange under section 354 or 356 for tion. The designation must be made on or
apply to determine the basis and holding stock of a controlled foreign corporation, before the first date on which the basis of
period of stock in a foreign corporation re- if— a share of stock received is relevant. The
ceived by certain shareholders in a section (i) Immediately before the exchange ei- basis of a share received, for example, is
354 or 356 exchange. In addition, special ther such shareholder is a section 1248 relevant when such share is sold or oth-
rules apply to determine the basis and shareholder with respect to the foreign ac- erwise transferred. The designation will
holding period of stock of certain foreign quired corporation, or such shareholder is be binding for purposes of determining the
surviving corporations held by a control- a foreign corporation and a United States Federal tax consequences of any sale or
ling corporation whose stock is issued in person is a section 1248 shareholder with transfer of a share received. If the share-
an exchange under section 354 or 356 in respect to both such foreign corporation holder fails to make a designation, then
a triangular reorganization. This section and the foreign acquired corporation; and the shareholder will not be able to identify
applies to transactions that are subject to (ii) The exchange is not described in which share is sold or transferred for pur-
section 367(b) as well as section 367(a), §1.367(b)–4(b)(1)(i), (2)(i), or (3). poses of determining the basis of property
including transactions concurrently sub- (2) Basis and holding period rules—(i) sold or transferred under section 1012 and
ject to sections 367(a) and (b). If a shareholder surrenders a share of stock §1.1012–1(c) and, instead, will be treated
(2) Definitions. For purposes of this in an exchange under the terms of section as selling or transferring the share received
section, the following definitions apply: 354 or 356, the basis and holding period in respect of the earliest share purchased or
(i) A foreign acquired corporation is of each share of stock received in the ex- acquired. See paragraph (e), Example 1 of
a foreign corporation whose stock or change shall be the same as the basis and this section for an illustration of this para-
assets are acquired by a foreign corpo- holding period of the allocable portion of graph (b).
ration in a reorganization described in the share or shares of stock exchanged (3) In the case of a triangular reorgani-
section 368(a)(1). In a reverse triangular therefor, as adjusted under §1.358–1 (such zation, this paragraph (b) applies only to
merger, where T is a foreign corpora- that the section 1248 amount of each share the exchange of T stock for P stock by
tion, T is treated as a foreign acquired of stock exchanged is preserved in the T shareholders. See paragraph (c) of this
corporation. A foreign corporation that share or shares of stock received). If more section to determine the basis and holding
undergoes a reorganization described in than one share of stock is received in ex- period of stock of the surviving corpora-
section 368(a)(1)(E) is treated as a foreign change for one share of stock, the basis tion (S or T) held by P immediately after a
acquired corporation. of the share of stock surrendered shall be triangular reorganization.
(ii) A block of stock has the meaning allocated to the shares of stock received in (4) Paragraphs (b)(1) through (3) of this
provided in §1.1248–2(b). the exchange in proportion to the fair mar- section shall not apply to determine the ba-
(iii) A triangular reorganization ket value of the shares of stock received. If sis of a share of stock received by a share-
is a reorganization described in one share of stock is received in respect of holder in an exchange described in both
§1.358–6(b)(2)(i), (ii), or (iii) (but more than one share of stock or a fraction section 351 and section 354 or 356, if, in
not a reorganization described in of a share of stock is received, the basis of connection with the exchange, the share-
§1.358–6(b)(2)(iv)). A triangular C the shares of stock surrendered must be al- holder exchanges property for stock in an
reorganization, a forward triangular located to the share of stock received, or a exchange to which neither section 354 nor
merger, and a reverse triangular merger fraction thereof received, in a manner that 356 applies or liabilities of the shareholder
each is a reorganization described in reflects, to the greatest extent possible, are assumed.
§1.358–6(b)(2)(i), (ii), or (iii), respec- that a share of stock is received in respect (c) Determination of basis and holding
tively. For purposes of triangular reorga- of shares of stock acquired on the same period for triangular reorganizations—(1)
nizations— date and at the same price. The provisions Application. In the case of a triangular
(A) P is a corporation that is a party to of this paragraph may be applied, to the reorganization, this paragraph (c) applies,
a reorganization that is in control (within extent possible, on the basis of blocks of if—
the meaning of section 368(c)) of another stock. (i) In the case of a reverse triangular
party to the reorganization and whose (ii) If a shareholder that purchased or merger—
stock is transferred pursuant to the reorga- acquired shares of stock in a corporation (A) Immediately before the transaction,
nization; on different dates or at different prices ex- either P is a section 1248 shareholder with
(B) S is a corporation that is a party to changes such shares of stock under the respect to S, or P is a foreign corpora-
the reorganization and that is controlled by terms of section 354 or 356, and the share- tion and a United States person is a sec-
P; and holder is not able to identify which partic-

February 14, 2005 551 2005–7 I.R.B.


tion 1248 shareholder with respect to both graph (c)(2)(ii) of this section to determine fair market value of the stock to which
P and S; and the basis and holding period of the sur- the portion is attributable at the time the
(B) P’s exchange of S stock is not de- viving corporation stock attributable to the portions were created.
scribed in §1.367(b)–3(a) and (b) or in T stock, and then increasing the basis of (iii) Shares of stock will no longer be
§1.367(b)–4(b)(1)(i), (2)(i), or (3); or each share of surviving corporation stock required to be divided if section 1248 or
(ii)(A) Immediately before the transac- by the proportionate amount of P’s aggre- section 964(e) would not apply to a dispo-
tion, a shareholder of T is either a section gate basis in the S stock immediately be- sition or exchange of such stock.
1248 shareholder with respect to T or a for- fore the exchange (without dividing the (2) Pre-exchange earnings and prof-
eign corporation and a United States per- stock of the surviving corporation into sep- its. All earnings and profits (or deficits)
son is a section 1248 shareholder with re- arate portions attributable to the S stock). accumulated by a foreign corporation be-
spect to both such foreign corporation and (ii) Portions attributable to T fore the reorganization and attributable to
T; and stock—(A) If any exchanging share- a share (or block) of stock for purposes of
(B) With respect to at least one of holder of T stock is described in para- section 1248 are attributable to the divided
the exchanging shareholders described graph (c)(1)(ii) of this section, the basis portion of stock with the basis and hold-
in paragraph (c)(1)(ii)(A) of this sec- and holding period of the portion of each ing period of that share (or block). See
tion, the exchange of T stock is not de- share of stock in the surviving corporation §1.367(b)–4(d).
scribed in §1.367(b)–3(a) and (b) or in attributable to the T stock is the basis and (3) Post-exchange earnings and prof-
§1.367(b)–4(b)(1)(i), (2)(i), or (3). holding period immediately before the its. Any earnings and profits (or deficits)
(2) Basis and holding period rules. In exchange of a proportionate amount of the accumulated by the surviving corporation
the case of a triangular reorganization de- T stock to which such portion relates. If subsequent to the reorganization are at-
scribed in this paragraph (c), each share any exchanging shareholder of T stock is tributed to each divided share of stock pur-
of stock of the surviving corporation (S described in paragraph (c)(1)(ii) of this suant to section 1248 and the regulations
or T) held by P must be divided into por- section, and such shareholder exchanges thereunder. The amount of earnings and
tions attributable to the S stock and the two or more blocks of T stock pursuant to profits (or deficits) attributable to a divided
T stock immediately before the exchange. the transaction, then each share of surviv- share of stock is further attributed to the di-
See paragraph (e) of this section, Examples ing corporation stock attributable to the T vided portions of such share of stock based
2 through 5 for illustrations of this rule. stock must be further divided into separate on the relative fair market value of each di-
(i) Portions attributable to S stock—(A) portions to account for the separate blocks vided portion of stock.
In the case of a forward triangular merger of T stock. (e) Examples. The rules of this section
or a triangular C reorganization, the basis (B) If no exchanging shareholder of T are illustrated by the following examples:
and holding period of the portion of each stock is described in paragraph (c)(1)(ii) Example 1. (i) Facts. US1 is a domestic corpo-
share of surviving corporation stock attrib- of this section, the rules of §1.358–6(c) ration that owns all the stock of FT, a foreign corpora-
tion with 100 shares of stock outstanding. Each share
utable to the S stock is the basis and hold- apply to determine the basis of the portion of FT stock is valued at $10x. Because US1 acquired
ing period of such share of stock immedi- of each share of the surviving corporation the stock of FT at two different dates, US1 owns two
ately before the exchange. attributable to T immediately before the blocks of FT stock for purposes of section 1248. The
(B) In the case of a reverse triangular exchange. first block consists of 60 shares. The shares in the first
merger, the basis and holding period of the (d) Special rules applicable to divided block have a basis of $300x ($5x per share), a hold-
ing period of 10 years, and $240x ($4x per share) of
portion of each share of surviving corpo- shares of stock—(1) In general—(i) Shares earnings and profits attributable to the shares for pur-
ration stock attributable to the S stock is of stock in different blocks can be aggre- poses of section 1248. The second block consists of
the basis and the holding period immedi- gated into one divided portion for basis 40 shares. The shares in the second block have a ba-
ately before the exchange of a proportion- purposes, if such shares immediately be- sis of $600x ($15x per share), a holding period of 2
ate amount of the S stock to which the fore the exchange are owned by one or years, and $80x ($2x per share) of earnings and prof-
its attributable to the shares for purposes of section
portion relates. If P is a shareholder de- more shareholders that are— 1248. US2, a domestic corporation, owns all of the
scribed in paragraph (c)(1)(i)(A) of this (A) Neither section 1248 shareholders stock of FP, a foreign corporation, which owns all of
section with respect to S, and P exchanges with respect to the corporation nor foreign the stock of FS, a foreign corporation. FT merges into
two or more blocks of S stock pursuant to corporate shareholders; or FS with FS surviving in a reorganization described in
the transaction, then each share of the sur- (B) Foreign corporate shareholders, section 368(a)(1)(A). Pursuant to the reorganization,
US1 receives 50 shares of FS stock with a value of
viving corporation (T) attributable to the S provided that no United States persons are $1,000x for its FT stock in an exchange that qualifies
stock must be further divided into separate section 1248 shareholders with respect to for nonrecognition under section 354.
portions to account for the separate blocks both such foreign corporate shareholders (ii) Basis and holding period determination—(A)
of stock in S. and the corporation. US1 is a section 1248 shareholder of FT immediately
(C) If the value of S stock immediately (ii) For purposes of determining the before the exchange and exchanges its FT stock for
stock of a controlled foreign corporation (FS) as to
before the triangular reorganization is less amount of gain realized on the sale or ex- which US1 is a section 1248 shareholder immediately
than one percent of the value of the sur- change of stock that has a divided portion after the exchange. US1 is not required to include
viving corporation stock immediately after pursuant to paragraph (c) of this section, income under §1.367(b)–4(b) with respect to the ex-
the triangular reorganization, then P may any amount realized on such sale or ex- change. Accordingly, the basis and holding period of
determine its basis in the surviving corpo- change will be allocated to each divided the FS stock received by US1 is determined pursuant
to paragraph (b) of this section.
ration stock by applying the rules of para- portion of the stock based on the relative

2005–7 I.R.B. 552 February 14, 2005


(B) Pursuant to paragraph (b) of this section, 30 (3) Because the exchanging shareholder of FT (B) Thus, each share of the surviving corpora-
shares of the FS stock received by US1 in the reor- stock (US1) is a section 1248 shareholder, the hold- tion (FT) will have a first portion (attributable to the
ganization (valued at $20x per share and exchanged ing period and basis of the FT portion is the hold- first block of FS stock) with a basis of $5x ($50x /
for US1’s first block of 60 shares of FT stock) have a ing period and the proportionate amount of the ba- 10 shares), a value of $20x ($200x / 10 shares), a
basis of $300x ($10x per share), a holding period of sis of the FT stock immediately before the exchange holding period of 10 years, and $5x of earnings and
10 years, and $240x of earnings and profits ($8x per to which such portion relates. Further, because US1 profits ($50x / 10 shares) attributable to such portion
share) attributable to such shares for purposes of sec- exchanged two blocks of FT stock, the FT portion for purposes of section 1248. Each share of FT stock
tion 1248. In addition, 20 shares of the FS stock (val- must be divided into two separate portions attribut- will have a second portion (attributable to the second
ued at $20 per share and exchanged for US1’s sec- able to the two blocks of FT stock. Thus, each share block of FS stock) with a basis of $10x ($100x / 10
ond block of 40 shares of FT stock) have a basis of of FS stock will have a second portion with a basis shares), a value of $20x ($200x / 10 shares), a hold-
$600x ($30x per share), a holding period of 2 years, of $15x ($300x basis / 20 shares), a value of $30x ing period of 5 years, and $2x of earnings and prof-
and $80x of earnings and profits ($4x per share) at- ($600x value / 20 shares), a holding period of 10 its ($20x / 10 shares) attributable to such portion for
tributable to such shares for purposes of section 1248. years, and $12x of earnings and profits ($240x / 20 purposes of section 1248. Moreover, each share of FT
(iii) Subsequent Disposition. Assume, subse- shares) attributable to such portion for purposes of stock will have a third portion (attributable to the first
quent to the exchange, US1 disposes of 20 shares of section 1248. Each share of FS stock will have a block of FT stock) with a basis of $30x ($300x basis /
FS stock. On or before the date of the disposition third portion with a basis of $30x ($600x basis / 20 10 shares), a value of $60x ($600x value / 10 shares),
when the basis of the F1 shares received by US1 shares), a value of $20x ($400x value / 20 shares), a a holding period of 10 years, and $24x of earnings and
becomes relevant, US1 can designate the 20 shares holding period of 2 years, and $4x of earnings and profits ($240x / 10 shares) attributable to such portion
from the first block, the second block, or from any profits ($80x / 20 shares) attributable to such portion for purposes of section 1248. Lastly, each share of
combination of shares in both blocks. for purposes of section 1248. FT stock will have a fourth portion (attributable to the
Example 2. (i) Facts. The facts are the same as in (iii) Assume, immediately after the transaction, second block of FT stock) with a basis of $60x ($600x
Example 1, except that US1 receives 50 shares of FP FP disposes of a share of FS stock from the first block. basis / 10 shares), a value of $40x ($400x value / 10
stock (instead of FS stock) with a value of $1,000x in When FP disposes of any share of its FS stock, it is shares), a holding period of 2 years, and $8x of earn-
exchange for its FT stock. Accordingly, the merger of treated as disposing of each divided portion of such ings and profits ($80x / 10 shares) attributable to such
FT into FS qualifies as forward triangular merger, and share. With respect to the first portion (attributable portion for purposes of section 1248.
immediately after the exchange US1 is a section 1248 to the FS stock), FP recognizes a gain of $15x ($20x Example 3. (i) Facts. USP, a domestic corpora-
shareholder with respect to FP and FS. Additionally, value - $5x basis), $5x of which is treated as a divi- tion, owns all the stock of FS, a foreign corporation
prior to the transaction, FP owned two blocks of FS dend under section 1248. With respect to the second with 10 shares of stock outstanding. Each share of FS
stock. Each block consisted of 10 shares with a value portion (attributable to the first block of FT stock), FP stock has a value of $10x, a basis of $5x, a holding
of $200x ($20x per share). The shares in the first recognizes a gain of $15x ($30x value - $15x basis), period of 10 years, and $7x of earnings and profits at-
block had a basis of $50x ($5x per share), a holding $12x of which is treated as a dividend under section tributable to such share for purposes of section 1248.
period of 10 years, and $50x ($5x per share) of earn- 1248. With respect to the third portion (attributable to FP, a foreign corporation, owns the stock of FT, an-
ings and profits attributable to such shares for pur- the second block of FT stock), FP recognizes a capi- other foreign corporation. FP and FT do not have any
poses of section 1248. The shares in the second block tal loss of $10x ($20x value - $30x basis). section 1248 shareholders. FT has assets with a value
had a basis of $100x ($10x per share), a holding pe- (iv) Assume further, immediately after the trans- of $100x, a basis of $50x, and no liabilities. The FT
riod of 5 years, and $20x ($2x per share) of earnings action, FP also disposes of a share of stock from the stock held by FP has a value of $100x and a basis
and profits attributable to such shares for purposes of second block of FS stock. With respect to the first of $75x. FT merges into FS with FS surviving in a
section 1248. portion (attributable to the FS stock), FP recognizes a forward triangular merger. Pursuant to the reorgani-
(ii) Basis and holding period determination. (A) gain of $10x ($20x value - $10x basis), $2x of which zation, FP receives USP stock with a value of $100x
The basis and holding period of the FP shares re- is treated as a dividend under section 1248. With re- in exchange for its FT stock.
ceived by US1 in the exchange are determined pur- spect to the second portion (attributable to the first (ii) Basis and holding period determination—(A)
suant to paragraph (b) of this section and are identical block of FT stock), FP recognizes a gain of $15x Because USP is a section 1248 shareholder of FS im-
to the results in Example 1. ($30x value - $15x basis), $12x of which is treated mediately before the transaction, the basis and hold-
(B)(1) US1 is a section 1248 shareholder of as a dividend under section 1248. With respect to ing period of the FS stock held by USP immediately
FT immediately before the transaction. More- the third portion (attributable to the second block of after the triangular reorganization is determined pur-
over, US1 is not required to include income under FT stock), FP recognizes a capital loss of $10x ($20x suant to paragraph (c) of this section.
§1.367(b)–3(b) or 1.367(b)–4(b) as described in value - $30x basis). (B) Pursuant to paragraph (c) of this section, each
paragraph (c)(2) of this section. Accordingly, the Example 2A. (i) Facts. The facts are the same as share of FS stock is divided into portions attributable
basis and holding period of the FS stock held by FP in Example 2, except that FS merges into FT with to the basis and holding period of the FS stock held
immediately after the triangular reorganization is FT surviving in a reverse triangular merger. Pursuant by USP immediately before the exchange (the FS por-
determined pursuant to paragraph (c) of this section. to the merger, US1 receives FP stock with a value tion) and the basis of FT’s net assets (the FT portion)
(2) Pursuant to paragraph (c) of this section, each of $1,000x in exchange for its FT stock, and FP re- immediately before the exchange. The basis of FT’s
share of FS stock is divided into portions attributable ceives 10 shares of FT stock with a value of $1,400x net assets (and not FT stock) is used to determine the
to the basis and holding period of the FS stock held by in exchange for its FS stock. Immediately after the FT portion because FT does not have a section 1248
FP immediately before the exchange (the FS portion) exchange, US1 is a section 1248 shareholder with re- shareholder immediately before the transaction. As
and the FT stock held by US1 immediately before the spect to FP and FT. a result, the rules of §1.358–6(c) apply to determine
exchange (the FT portion). The basis and holding pe- (ii) Basis and holding period determination—(A) the basis of the FT portion of each share of FS stock.
riod of the FS portion is the basis and holding period The basis and holding period of the FP shares re- The basis and holding period of the FS portion is the
of the FS stock held by FP immediately before the ceived by US1 and the stock of the surviving corpora- basis and holding period of the FS stock held by USP
exchange. Thus, each share of FS stock in the first tion held by FP are the same as in Example 2, except immediately before the exchange. Thus, each share
block has a portion with a basis of $5x, a value of that each share of the surviving corporation (FT, in- of FS stock has a portion with a basis of $5x, a value
$20x, a holding period of 10 years, and $5x of earn- stead of FS) will be divided into four portions instead of $10x, and a holding period of 10 years. The ba-
ings and profits attributable to such portion for pur- of three portions. Because FP exchanges two blocks sis of the FT portion is the basis of the FT assets to
poses of section 1248. Each share of FS stock in the of FS stock, the FS portion must be divided into two which such portion relates. Thus, each share of FS
second block has a portion with a basis of $10x, a separate portions attributable to the two blocks of FS stock has a second portion with a basis of $5x ($50x
value of $20x, a holding period of 5 years, and $2x stock. Because US1 exchanges two blocks of FT basis in FT’s assets / 10 shares) and a value of $10x
of earnings and profits attributable to such portion for stock, the FT portion must be divided into two sep- ($100x value of FT’s assets / 10 shares). All of FS’s
purposes of section 1248. arate portions attributable to the two blocks of FT earnings and profits prior to the transaction ($70x) is
stock. attributed solely to the FS portion in each share of FS

February 14, 2005 553 2005–7 I.R.B.


stock. The FS portion of each share of FS stock has $200x for its FT stock in an exchange that qualifies each divided portion of stock. Accordingly, one-third
earnings and profits of $7x ($70x / 10 shares) attribut- for non-recognition under section 354. FP is a con- of the post-merger earnings and profits deficit of $30x
able to such portion for purposes of section 1248. As trolled foreign corporation and US is a section 1248 is allocated to the FS portion of each share and two-
a result of each share of stock being divided into por- shareholder with respect to FP and FS immediately thirds to the FT portion of each share. Thus, the
tions, the basis of the FS stock is not averaged with after the exchange. deficit in earnings and profits allocated to the FS por-
the basis of the FT assets to increase the section 1248 (ii) Basis and holding period determination. (A) tion of each share is $1x (one-third of $30x divided
amount with respect to the stock of the surviving cor- Because US is a section 1248 shareholder of FT im- by 10 shares). The deficit in earnings and profits al-
poration (FS). mediately before the transaction, and US is not re- located to the FT portion of each share is $2x (two-
Example 4. (i) Facts. US, a domestic corporation, quired to include income under §§1.367(b)–3(b) and thirds of $30x divided by 10 shares).
owns all of the stock of FT, a foreign corporation. 1.367(b)–4(b) as described in paragraph (c)(2) of this (D) When FP disposes of its FS stock, FP is
The FT stock held by US constitutes a single block section, the basis and holding period of the FS stock treated as disposing of each divided portion of a
of stock with a value of $1,000x, a basis of $600x, held by FP immediately after the triangular reorgani- share of stock. With respect to the FS portion of
and holding period of 5 years. USP, a domestic cor- zation is determined pursuant to paragraph (c) of this each share of stock, FP recognizes a gain of $2x ($7x
poration, forms FS, a foreign corporation, pursuant section. value - $5x basis), which is not recharacterized as
to the plan of reorganization and capitalizes it with (B) Pursuant to paragraph (c) of this section, each a dividend because a deficit in earnings and profits
$10x of cash. FS merges into FT with FT surviving share of FS stock is divided into portions attributable of $1x is attributable to such portion for purposes of
in a reverse triangular merger and a reorganization de- to the basis and holding period of the FS stock held by section 1248. With respect to the FT portion of each
scribed in section 368(a)(1)(B). Pursuant to the reor- FP immediately before the exchange (the FS portion) share of stock, FP recognizes a loss of $3x ($14x
ganization, US receives USP stock with a value of and the FT stock held by US immediately before the value - $17x basis).
$1,000x in exchange for its FT stock, and USP re- exchange (the FT portion). The basis and holding pe- (e) Effective date. This section applies
ceives 10 shares of FT stock with a value of $1,010x riod of the FS portion is the basis and holding period to exchanges occurring after the date these
in exchange for its FS stock. of the FS stock held by FP immediately before the
(ii) Basis and holding period determination. (A) exchange. Thus, each share of FS stock has a por-
regulations are published as final regula-
US and USP are section 1248 shareholders of FT and tion with a basis of $5x and a value of $10x. Because tions in the Federal Register.
FS, respectively, immediately before the transaction. the exchanging shareholder of FT stock (US) is a sec- Par. 11. Section 1.884–2 is amended
Neither US nor USP is required to include income un- tion 1248 shareholder of FT, the basis and holding as follows:
der §1.367(b)–3(b) or 1.367(b)–4(b) as described in period of the FT portion is the proportionate amount 1. Paragraphs (c)(3) through (c)(6)
paragraph (c)(2) of this section. The basis and hold- of the basis and the holding period of the FT stock
ing period of the FT stock held by USP is determined immediately before the exchange to which such por-
(i)(A) are revised.
pursuant to paragraph (c) of this section. tion relates. Thus, each share of FS stock will have 2. Paragraphs (c)(6)(i)(B), (C), and (D)
(B) Pursuant to paragraph (c) of this section, a second portion with a basis of $17x ($170x basis / are added.
because the exchanging shareholder of FT stock 10 shares), a value of $20x ($200x value / 10 shares), 3. Paragraphs (c)(6)(ii) through (f) are
(US) is a section 1248 shareholder of FT, each share a holding period of 5 years, and $1x of earnings and revised.
of the surviving corporation (FT) has a proportionate profits ($10x earnings and profits / 10 shares) attrib-
amount of the basis and holding period of the FT utable to such portion for purposes of section 1248.
4. Paragraph (g) is amended by adding
stock immediately before the exchange to which such (iii) Subsequent disposition. (A) Several years a sentence at the end.
share relates. Thus, the portion of each share of FT after the merger, FP disposes of all of its FS stock in The revisions and additions read as fol-
stock attributable to the FT stock has a basis of $60x a transaction governed by section 964(e). At the time lows:
($600x basis / 10 shares), a value of $100x ($1,000x of the disposition, FS stock has decreased in value to
value / 10 shares), and a holding period of 5 years. $210x (a post-merger reduction in value of $90x), and §1.884–2 Special rules for termination
Because the value of FS stock immediately before FS has incurred a post-merger deficit in earnings and
or incorporation of a U.S. trade or
the triangular reorganization ($10x) is less than one profits of $30x.
percent of the value of the surviving corporation (B) Pursuant to paragraph (d)(1)(ii) of this sec- business or liquidation or reorganization
(FT) immediately after the triangular reorganization tion, for purposes of determining the amount of gain of a foreign corporation or its domestic
($1,010x), USP may determine its basis in the stock realized on the sale or exchange of stock that has a subsidiary.
of the surviving corporation (FT) by increasing the divided portion, any amount realized on such sale
basis of each share of FT stock by the proportionate or exchange is allocated to each divided portion of *****
amount of USP’s aggregate basis in the FS stock the stock based on the relative fair market value of (c)(3) through (c)(6)(i)(A) [Re-
immediately before the exchange (without dividing the stock to which the portion is attributable at the
each share of FT stock into separate portions to ac- time the portions were created. Immediately before
served]. For further guidance, see
count for FS and FT). If USP so elects, USP’s basis the merger, the value of the FS stock in relation to §1.884–2T(c)(3) through (c)(6)(i)(A).
in each share of FT stock is increased by $1x ($10x the value of both the FS stock and the FT stock was (c)(6)(i)(B) Shareholders of the trans-
basis in FS stock / 10 shares). As a result, each share one-third ($100x / ($100x plus $200x)). Likewise, feree (or of the transferee’s parent in
of FT stock has a basis of $61x, a value of $101x, immediately before the merger, the value of the FT the case of a triangular reorganization
and a holding period of 5 years. stock in relation to the value of both the FT stock
Example 5. (i) Facts. US, a domestic corpora- and the FS stock was two-thirds ($200x / $100x plus
described in section 368(a)(1)(C) or
tion, owns all of the stock of FT, a foreign corpora- $200x). Accordingly, one-third of the $210x amount a reorganization described in sections
tion. The FT stock held by US constitutes one block realized is allocated to the FS portion of each share 368(a)(1)(A) and 368(a)(2)(D) or (E))
of stock with a basis of $170x, a value of $200x, a and two-thirds to the FT portion of each share. Thus, who in the aggregate owned more than
holding period of 5 years, and $10x of earnings and the amount realized allocated to the FS portion of 25 percent of the value of the stock of the
profits attributable to such stock for purposes of sec- each share is $7x (one-third of $210x divided by 10
tion 1248. FP, a foreign corporation, owns all the shares). The amount realized allocated to the FT por-
transferor at any time within the 12-month
stock of FS, a foreign corporation. FS has 10 shares tion of each share is $14x (two-thirds of $210x di- period preceding the close of the year in
of stock outstanding. No United States person is a vided by 10 shares). which the section 381(a) transaction oc-
section 1248 shareholder with respect to FP or FS. (C) Pursuant to paragraph (d)(3) of this section, curs sell, exchange or otherwise dispose
The FS stock held by FP has a value of $100x and a any earnings and profits (or deficits) accumulated by of their stock or securities in the transferee
basis of $50x ($5x per share). FT merges into FS with the surviving corporation subsequent to the reorgani-
FS surviving in a forward triangular merger. Pursuant zation are attributed to the divided portions of shares
at any time during a period of three years
to the merger, US receives FP stock with a value of of stock based on the relative fair market value of

2005–7 I.R.B. 554 February 14, 2005


from the close of the taxable year in which date on which the additional tax for that the Archer MSA pilot project. The Inter-
the section 381(a) transaction occurs. year is paid. Any such additional tax lia- nal Revenue Service (IRS) has determined
(c)(6)(i)(C) In the case of a triangu- bility together with interest thereon shall that the applicable number of Archer MSA
lar reorganization described in section be the liability of the transferee within the returns filed for 2003 is 60,832 and that the
368(a)(1)(C) or a reorganization described meaning of section 6901 pursuant to sec- applicable number of Archer MSA returns
in sections 368(a)(1)(A) and 368(a)(2)(D) tion 6901 and the regulations there under. projected to be filed for 2004 is 56,492
or (E), the transferee’s parent sells, ex- (c)(6)(ii) through (f) [Reserved]. For (after reduction in each case for statutorily
changes, or otherwise disposes of its stock further guidance, see §1.884–2T(c)(6)(ii) specified exclusions, such as the exclu-
or securities in the transferee at any time through (f). sion for previously uninsured taxpayers).
during a period of three years from the (g) * * * Paragraphs (c)(6)(i)(B), (C), Consequently, February 1, 2005, is not a
close of the taxable year in which the sec- and (D), are applicable for tax years be- “cut-off” date and 2004 is not a “cut-off’
tion 381(a) transaction occurs. ginning after December 31, 1986, except year for the Archer MSA pilot project.
(c)(6)(i)(D) A corporation related to that such paragraphs are applicable to
any such shareholder or the shareholder it- transactions occurring after the date these BACKGROUND
self if it is a corporation (subsequent to an regulations are published as final regula-
event described in paragraph (c)(6)(i)(A) tions in the Federal Register in the case The Health Insurance Portability and
or (B) of this section) or the transferee’s of reorganizations described in sections Accountability Act of 1996 added section
parent (subsequent to an event described 368(a)(1)(A) and 368(a)(2)(D) or (E). 220 to the Code to permit eligible individu-
in paragraph (c)(6)(i)(C) of this section), Par. 12. In §1.884–2T, paragraphs als to establish Archer MSAs under a pilot
uses, directly or indirectly, the proceeds or (c)(6)(i)(B), (C), and (D) are revised to project effective January 1, 1997. The
property received in such sale, exchange read as follows: pilot project, as amended by The Working
or disposition, or property attributable Families Tax Relief Act of 2004 (WFTRA)
thereto, in the conduct of a trade or busi- §1.884–2T Special rules for termination § 322, has a scheduled “cut-off” year of
ness in the United States at any time during or incorporation of a U.S. trade or 2005, but may have an earlier “cut-off”
a period of three years from the date of sale business or liquidation or reorganization year if the number of individuals who
in the case of a disposition of stock in the of a foreign corporation or its domestic have established Archer MSAs exceeds
transferor, or from the close of the taxable subsidiary (Temporary). certain numerical limitations. Trustees’
year in which the section 381(a) transac- reports for Archer MSAs established from
tion occurs in the case of a disposition ***** January 1, 2004, through June 30, 2004,
of the stock or securities in the transferee (c) * * * were due no later than January 3, 2005.
(or the transferee’s parent in the case of (6) * * * IRS is required to publish a determination
a triangular reorganization described in (i) * * * of whether 2004 is a “cut-off” year no
section 368(a)(1)(C) or a reorganization (B), (C), and (D) [Reserved]. For fur- later than February 1, 2005. See sections
described in sections 368(a)(1)(A) and ther guidance, see §1.884–2(c)(6)(i)(B), 220(i) and (j) as amended by WFTRA;
(a)(2)(D) or (E)). Where this paragraph (C), and (D). Ann. 2004–82, 2004–45 I.R.B. 834.
(c)(6)(i) applies, the transferor’s branch If a year is a “cut-off” year, section
profits tax liability for the taxable year in Mark E. Matthews, 220(i)(1) generally provides that no in-
which the section 381(a) transaction oc- Deputy Commissioner for dividual will be eligible for a deduction
curs shall be determined under §1.884–1, Services and Enforcement. or exclusion for Archer MSA contribu-
taking into account all the adjustments (Filed by the Office of the Federal Register on January 4,
tions for any taxable year beginning af-
in U.S. net equity that result from the 2005, 8:45 a.m., and published in the issue of the Federal ter the “cut-off’ year unless the individ-
Register for January 5, 2005, 70 F.R. 749)
transfer of U.S. assets and liabilities to the ual (A) was an active Archer MSA partic-
transferee pursuant to the section 381(a) ipant for any taxable year ending on or be-
transaction, without regard to any provi- fore the close of the “cut-off” year, or (B)
sions in this paragraph (c). If an event Archer MSAs first became an active Archer MSA par-
described in paragraph (c)(6)(i)(A), (B), ticipant for a taxable year ending after the
or (C) of this section occurs after the close Announcement 2005–12 “cut-off” year by reason of coverage under
of the taxable year in which the section a high deductible health plan of an Archer
381(a) transaction occurs, and if additional PURPOSE MSA-participating employer.
branch profits tax is required to be paid Section 220(j)(2)(A) provides that the
by reason of the application of this para- Sections 220(i) and (j) of the Internal numerical limitation for 2004 is exceeded
graph (c)(6)(i), then interest must be paid Revenue Code provide that if the num- if the number of Archer MSA returns filed
on that amount at the underpayment rates ber of Archer Medical Savings Account on or before April 15, 2004, for taxable
determined under section 6621(a)(2), with (Archer MSA) returns filed for 2003 or years ending with or within the 2003 cal-
respect to the period between the date that a statutorily specified projection of the endar year, plus the Secretary’s estimate
was prescribed for filing the transferor’s number of Archer MSA returns that will of the number of Archer MSA returns for
income tax return for the year in which the be filed for 2004 exceeds 750,000, then those taxable years which will be filed
section 381(a) transaction occurs and the February 1, 2005, is a “cut-off” date for after April 15, 2004, exceeds 750,000.

February 14, 2005 555 2005–7 I.R.B.


For this purpose, section 220(j)(2)(A) pro- an Archer MSA for the 2003 taxable year were reported by trustees and custodians
vides that a tax return is an Archer MSA were filed by April 15, 2004. Of this to- as excludable from the count because his
return for a taxable year if any exclusion tal, 15,513 taxpayers were reported as be- or her spouse also established an Archer
is claimed under section 106(b) or any ing previously uninsured. It has been es- MSA. Accordingly, the applicable number
deduction is claimed under section 220 timated that an additional 13,220 tax re- of Archer MSAs established from January
for that taxable year. Section 220(j)(2)(B) turns reporting Archer MSA contributions 1, 2004, through June 30, 2004, is 697
provides, as an alternative test, that the for the 2003 taxable year have been or (4,062 minus (3,362 plus 3)). The alterna-
numerical limitation for 2004 is also ex- will be filed after April 15, 2004, includ- tive limitation for 2004 (90 percent of the
ceeded if the sum of 90 percent of the ing 2,890 taxpayers who were previously applicable number of Archer MSA returns
Archer MSA returns for 2003 plus the uninsured. Accordingly, it has been deter- for 2003 plus the product of 2.5 and the
product of 2.5 and the number of Archer mined that there were 79,235 (66,015 plus number of applicable Archer MSAs estab-
MSAs for taxable years beginning in 2004 13,220) Archer MSA returns for 2003. Of lished from January 1, 2004, through June
that are established during the portion of this total, 18,403 (15,513 plus 2,890) were 30, 2004) is 56,492 (90 percent of 60,832
2004 preceding July 1 (based on reports for taxpayers reported as being previously plus 2.5 multiplied by 697), which is less
by Archer MSA trustees and custodians), uninsured. As a result, 60,832 (79,235 mi- than the statutory limit of 750,000. Thus,
exceeds 750,000. nus 18,403) Archer MSA returns count to- 2004 is not a “cut-off” year for the Archer
Under section 220(j)(3), in determining ward the applicable statutory limitation for MSA pilot project by reason of either the
whether any calendar year is a “cut-off” 2004 Archer MSA returns of 750,000. 2004 Archer MSA returns test of section
year, the Archer MSA of any previously Based on the Forms 8851 filed on or 220(j)(2)(A) or the alternative test of sec-
uninsured individual is not taken into ac- before January 3, 2005, by Archer MSA tion 220(j)(2)(B) of the Code.
count. In addition, section 220(j)(4)(D) trustees and custodians, it has been deter- Questions regarding this announcement
specifies that, to the extent practical, all mined that 4,062 taxpayers who did not may be directed to Elizabeth Purcell in
Archer MSAs established by an individual have Archer MSA contributions for 2003 the Office of Division Counsel/Associate
are aggregated and two married individu- established Archer MSAs for 2004 during Chief Counsel (Tax Exempt and Govern-
als opening separate Archer MSAs are to the portion of 2004 preceding July 1. Of ment Entities) at (202) 622–6080 (not a
be treated as having a single Archer MSA this total, 3,362 taxpayers were reported toll-free number).
for purposes of determining the number of by trustees and custodians as previously
Archer MSAs. uninsured, and therefore are not taken into
A total of 66,015 tax returns reporting account in determining whether 2004 is a
an excludable or deductible contribution to “cut-off” year. In addition, 3 taxpayers

2005–7 I.R.B. 556 February 14, 2005


Definition of Terms
Revenue rulings and revenue procedures and B, the prior ruling is modified because of a prior ruling, a combination of terms
(hereinafter referred to as “rulings”) that it corrects a published position. (Compare is used. For example, modified and su-
have an effect on previous rulings use the with amplified and clarified, above). perseded describes a situation where the
following defined terms to describe the ef- Obsoleted describes a previously pub- substance of a previously published ruling
fect: lished ruling that is not considered deter- is being changed in part and is continued
Amplified describes a situation where minative with respect to future transac- without change in part and it is desired to
no change is being made in a prior pub- tions. This term is most commonly used in restate the valid portion of the previously
lished position, but the prior position is be- a ruling that lists previously published rul- published ruling in a new ruling that is self
ing extended to apply to a variation of the ings that are obsoleted because of changes contained. In this case, the previously pub-
fact situation set forth therein. Thus, if in laws or regulations. A ruling may also lished ruling is first modified and then, as
an earlier ruling held that a principle ap- be obsoleted because the substance has modified, is superseded.
plied to A, and the new ruling holds that the been included in regulations subsequently Supplemented is used in situations in
same principle also applies to B, the earlier adopted. which a list, such as a list of the names of
ruling is amplified. (Compare with modi- Revoked describes situations where the countries, is published in a ruling and that
fied, below). position in the previously published ruling list is expanded by adding further names in
Clarified is used in those instances is not correct and the correct position is subsequent rulings. After the original rul-
where the language in a prior ruling is be- being stated in a new ruling. ing has been supplemented several times, a
ing made clear because the language has Superseded describes a situation where new ruling may be published that includes
caused, or may cause, some confusion. the new ruling does nothing more than re- the list in the original ruling and the ad-
It is not used where a position in a prior state the substance and situation of a previ- ditions, and supersedes all prior rulings in
ruling is being changed. ously published ruling (or rulings). Thus, the series.
Distinguished describes a situation the term is used to republish under the Suspended is used in rare situations
where a ruling mentions a previously pub- 1986 Code and regulations the same po- to show that the previous published rul-
lished ruling and points out an essential sition published under the 1939 Code and ings will not be applied pending some
difference between them. regulations. The term is also used when future action such as the issuance of new
Modified is used where the substance it is desired to republish in a single rul- or amended regulations, the outcome of
of a previously published position is being ing a series of situations, names, etc., that cases in litigation, or the outcome of a
changed. Thus, if a prior ruling held that a were previously published over a period of Service study.
principle applied to A but not to B, and the time in separate rulings. If the new rul-
new ruling holds that it applies to both A ing does more than restate the substance

Abbreviations
The following abbreviations in current use ER—Employer. PRS—Partnership.
and formerly used will appear in material ERISA—Employee Retirement Income Security Act. PTE—Prohibited Transaction Exemption.
EX—Executor. Pub. L.—Public Law.
published in the Bulletin.
F—Fiduciary. REIT—Real Estate Investment Trust.
FC—Foreign Country. Rev. Proc.—Revenue Procedure.
A—Individual.
FICA—Federal Insurance Contributions Act. Rev. Rul.—Revenue Ruling.
Acq.—Acquiescence.
B—Individual. FISC—Foreign International Sales Company. S—Subsidiary.
FPH—Foreign Personal Holding Company. S.P.R.—Statement of Procedural Rules.
BE—Beneficiary.
F.R.—Federal Register. Stat.—Statutes at Large.
BK—Bank.
B.T.A.—Board of Tax Appeals. FUTA—Federal Unemployment Tax Act. T—Target Corporation.
FX—Foreign corporation. T.C.—Tax Court.
C—Individual.
G.C.M.—Chief Counsel’s Memorandum. T.D. —Treasury Decision.
C.B.—Cumulative Bulletin.
CFR—Code of Federal Regulations. GE—Grantee. TFE—Transferee.
GP—General Partner. TFR—Transferor.
CI—City.
GR—Grantor. T.I.R.—Technical Information Release.
COOP—Cooperative.
Ct.D.—Court Decision. IC—Insurance Company. TP—Taxpayer.
I.R.B.—Internal Revenue Bulletin. TR—Trust.
CY—County.
LE—Lessee. TT—Trustee.
D—Decedent.
DC—Dummy Corporation. LP—Limited Partner. U.S.C.—United States Code.
LR—Lessor. X—Corporation.
DE—Donee.
M—Minor. Y—Corporation.
Del. Order—Delegation Order.
DISC—Domestic International Sales Corporation. Nonacq.—Nonacquiescence. Z —Corporation.
O—Organization.
DR—Donor.
P—Parent Corporation.
E—Estate.
EE—Employee. PHC—Personal Holding Company.
PO—Possession of the U.S.
E.O.—Executive Order.
PR—Partner.

February 14, 2005 i 2005–7 I.R.B.


Numerical Finding List1 Revenue Rulings:
Bulletins 2005–1 through 2005–7 2005-1, 2005-2 I.R.B. 258
Announcements: 2005-2, 2005-2 I.R.B. 259
2005-3, 2005-3 I.R.B. 334
2005-1, 2005-1 I.R.B. 257 2005-4, 2005-4 I.R.B. 366
2005-2, 2005-2 I.R.B. 319 2005-5, 2005-5 I.R.B. 445
2005-3, 2005-2 I.R.B. 270 2005-6, 2005-6 I.R.B. 471
2005-4, 2005-2 I.R.B. 319 2005-7, 2005-6 I.R.B. 464
2005-5, 2005-3 I.R.B. 353 2005-8, 2005-6 I.R.B. 466
2005-6, 2005-4 I.R.B. 377 2005-9, 2005-6 I.R.B. 470
2005-7, 2005-4 I.R.B. 377 2005-10, 2005-7 I.R.B. 492
2005-8, 2005-4 I.R.B. 380
Tax Conventions:
2005-9, 2005-4 I.R.B. 380
2005-10, 2005-5 I.R.B. 450 2005-3, 2005-2 I.R.B. 270
2005-11, 2005-5 I.R.B. 451
2005-12, 2005-7 I.R.B. 555 Treasury Decisions:

Notices: 9164, 2005-3 I.R.B. 320


9165, 2005-4 I.R.B. 357
2005-1, 2005-2 I.R.B. 274 9167, 2005-2 I.R.B. 261
2005-2, 2005-3 I.R.B. 337 9168, 2005-4 I.R.B. 354
2005-3, 2005-5 I.R.B. 447 9169, 2005-5 I.R.B. 381
2005-4, 2005-2 I.R.B. 289 9170, 2005-4 I.R.B. 363
2005-5, 2005-3 I.R.B. 337 9171, 2005-6 I.R.B. 452
2005-6, 2005-5 I.R.B. 448 9172, 2005-6 I.R.B. 468
2005-7, 2005-3 I.R.B. 340
2005-8, 2005-4 I.R.B. 368
2005-9, 2005-4 I.R.B. 369
2005-10, 2005-6 I.R.B. 474
2005-11, 2005-7 I.R.B. 493
2005-12, 2005-7 I.R.B. 494
2005-14, 2005-7 I.R.B. 498
2005-15, 2005-7 I.R.B. 527

Proposed Regulations:

REG-117969-00, 2005-7 I.R.B. 533


REG-125628-01, 2005-7 I.R.B. 536
REG-129709-03, 2005-3 I.R.B. 351
REG-139683-04, 2005-4 I.R.B. 371
REG-152945-04, 2005-6 I.R.B. 484
REG-159824-04, 2005-4 I.R.B. 372

Revenue Procedures:

2005-1, 2005-1 I.R.B. 1


2005-2, 2005-1 I.R.B. 86
2005-3, 2005-1 I.R.B. 118
2005-4, 2005-1 I.R.B. 128
2005-5, 2005-1 I.R.B. 170
2005-6, 2005-1 I.R.B. 200
2005-7, 2005-1 I.R.B. 240
2005-8, 2005-1 I.R.B. 243
2005-9, 2005-2 I.R.B. 303
2005-10, 2005-3 I.R.B. 341
2005-11, 2005-2 I.R.B. 307
2005-12, 2005-2 I.R.B. 311
2005-14, 2005-7 I.R.B. 528

1 A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2004–27 through 2004–52 is in Internal Revenue Bulletin
2004–52, dated December 27, 2004.

2005–7 I.R.B. ii February 14, 2005


Finding List of Current Actions on Revenue Procedures— Continued:
Previously Published Items1 2004-6
Superseded by
Bulletins 2005–1 through 2005–7
Rev. Proc. 2005-6, 2005-1 I.R.B. 200
Notices:
2004-7
88-30 Superseded by
Obsoleted by Rev. Proc. 2005-7, 2005-1 I.R.B. 240
Notice 2005-4, 2005-2 I.R.B. 289 2004-8
88-132 Superseded by
Obsoleted by Rev. Proc. 2005-8, 2005-1 I.R.B. 243
Notice 2005-4, 2005-2 I.R.B. 289 2004-35
89-29 Corrected by
Obsoleted by Ann. 2005-4, 2005-2 I.R.B. 319
Notice 2005-4, 2005-2 I.R.B. 289 2004-60
89-38 Superseded by
Obsoleted by Rev. Proc. 2005-10, 2005-3 I.R.B. 341
Notice 2005-4, 2005-2 I.R.B. 289 Revenue Rulings:
Proposed Regulations:
92-63
REG-149519-03 Modified and superseded by
Corrected by Rev. Rul. 2005-3, 2005-3 I.R.B. 334
Ann. 2005-11, 2005-5 I.R.B. 451 95-63
REG-114726-04 Modified and superseded by
Corrected by Rev. Rul. 2005-3, 2005-3 I.R.B. 334
Ann. 2005-10, 2005-5 I.R.B. 450 2004-43
Revenue Procedures: Revoked by
Rev. Rul. 2005-10, 2005-7 I.R.B. 492
98-16
2004-103
Modified and superseded by
Superseded by
Rev. Proc. 2005-11, 2005-2 I.R.B. 307
Rev. Rul. 2005-3, 2005-3 I.R.B. 334
2001-22
Superseded by
Rev. Proc. 2005-12, 2005-2 I.R.B. 311

2002-9
Modified and amplified by
Rev. Proc. 2005-9, 2005-2 I.R.B. 303

2004-1
Superseded by
Rev. Proc. 2005-1, 2005-1 I.R.B. 1

2004-2
Superseded by
Rev. Proc. 2005-2, 2005-1 I.R.B. 86

2004-3
Superseded by
Rev. Proc. 2005-3, 2005-1 I.R.B. 118

2004-4
Superseded by
Rev. Proc. 2005-4, 2005-1 I.R.B. 128

2004-5
Superseded by
Rev. Proc. 2005-5, 2005-1 I.R.B. 170

1 A cumulative list of current actions on previously published items in Internal Revenue Bulletins 2004–27 through 2004–52 is in Internal Revenue Bulletin 2004–52, dated December 27,
2004.

February 14, 2005 iii *U.S. Government Printing Office: 2005—310–365/70002 2005–7 I.R.B.